October 06, 2023
Software capitalization refers to the accounting procedure that allows organizations to allocate expenditures associated with developing or obtaining computer software. In the case of external use software capitalization, the software is being developed or obtained for external customers. Companies can also capitalize internal-use software.
Under International Financial Reporting Standards (IFRS), specifically IAS 38 – Intangible Assets, the costs of developing external-use software are capitalized if certain criteria are met:
- it is probable that there will be future economic benefits from the asset; and
- the cost of the asset can be reliably measured.
Properly following software capitalization rules for external-use software is crucial for accurate financial reporting and decision-making. It allows organizations to allocate costs appropriately, recognize expenses over the software’s useful life, and track the economic benefits derived from software development investments. Compliance with these rules ensures transparency and consistency in financial statements, providing stakeholders with reliable information for evaluating an organization’s financial performance and stability
The primary purpose behind external use software capitalization is to ensure accurate reflection and tracking of an organization’s investment in software solutions. Companies often invest significant resources into the research, design, coding, testing, debugging, documentation, and training materials production for new external software products.
In many technology-intensive organizations, these efforts are deemed essential for generating future revenues and acquiring new customers in a competitive market landscape. To achieve the greatest success from external software capitalization, organizations must use this strategy correctly.
External Use Software Capitalization Standards and Regulations
External-use software capitalization standards and regulations play a significant role in financial reporting. Companies that develop or acquire software for external users are required to follow these rules, which fall under the Generally Accepted Accounting Principles (GAAP). The standards dictate how companies must account for costs related to developing, purchasing, and implementing software that is either sold or licensed to external customers.
Software capitalization rules are an important aspect of these regulations. They help determine when and how development costs should be capitalized rather than expensed. Under GAAP, companies are required to capitalize certain costs associated with creating or acquiring software once technological feasibility has been established.
Organization leaders should monitor for technological feasibility, which is typically achieved when an organization can demonstrate that software will meet its intended purpose either through a detailed program design OR a working model.
Software capitalization rules for external use software require organizations to recognize various types of costs during different stages of the development process. In the preliminary stage, all costs are expensed as they arise.
Once technological feasibility has been established and development begins in earnest, companies must capitalize certain expenses including coding, testing, and documentation.
After the product is available for general release to customers, any additional maintenance or enhancement costs must be expensed as they occur. According GAAP criteria, only direct production costs should be capitalized.
Indirect expenses like overhead and general administrative expenses should continue to be expensed. To avoid compliance problems, organizations should only capitalize those costs that can be reasonably allocated to producing the external-use software product in question.
External use software capitalization criteria also extend beyond initial development expenses. Companies must consider ongoing, post-implementation support and maintenance activities. If these enhance or extend a product’s functionality, they may qualify for capitalization. For example, costs associated with bug fixes and routine maintenance should typically be expensed. However, costs related to significant upgrades or enhancements that result in additional functionality may qualify for capitalization.
To ensure compliance with external use software capitalization standards and regulations, companies must have a well-defined software capitalization process in place. This process should include clear documentation of development activities, accurate allocation of expenses between capitalized and expensed categories, and regular reviews to ensure that capitalized costs are appropriately amortized over the software’s useful life.
It is vital for companies developing or acquiring external use software to understand and adhere to the various software capitalization GAAP standards. Doing so allows organizations to accurately report their financial performance related to software investments. It also enables them to manage costs effectively during the development process and maintain transparency with shareholders/stakeholders regarding their financial standing.
Benefits and Challenges of External Use Software Capitalization
Businesses should consider the benefits and challenges of external use software capitalization before investing in software development processes. This evaluation allows organizations to better understand the potential gains and pitfalls of capitalizing their software development costs and make informed decisions about the value of such investments.
Capitalization of software development costs allows companies to defer recognition of certain development costs. With this approach, costs are spread over time instead of making a significant impact on financial statements. This approach can improve a company’s perceived financial health by smoothing out its expenditures over a longer period.
There are several notable software capitalization benefits. This method enables companies to align their financial reporting with the useful life and revenue generation potential of the developed software. By capitalizing on these costs, businesses can reflect their long-term investment in creating valuable assets that will drive future revenues. This accounting treatment also acknowledges the fact that software development is often iterative and requires continuous refinement.
It promotes an accurate representation of ongoing investments in product improvement and new feature additions that contribute to short-term progress and long-term success. Organizations may also experience tax advantages from capitalizing on their software development costs. These benefits arise through depreciation deductions or tax credits available for certain research and development activities tied to technological innovation.
Company leaders should also be aware that there are some software capitalization challenges. One significant concern is the increased complexity involved in tracking capitalized expenses accurately and consistently. Maintaining comprehensive records related to each phase of development work can become burdensome for organizations that don’t already have robust systems in place.
Determining appropriate amortization schedules – which dictate how quickly these capitalized expenses must be written off against future revenues – can also prove challenging due to market changes. There is also some risk of distorted financial forecasts. Capitalizing costs can improve a company’s short-term profitability and cash flow but may create an overly optimistic picture of its financial performance.
That can lead to overvaluation or unrealistic growth expectations, potentially harming investors or stakeholders in the long run. Businesses that rely on capitalizing software development expenses may also face heightened scrutiny from regulatory bodies or external auditors. The more aggressively an organization pursues this accounting tactic, the greater the risk of attracting unwanted attention around financial practices.
There is no doubt that external software capitalization offers some clear benefits, including better alignment between financial reporting and software value creation, potential tax advantages, and enhanced recognition of ongoing investments in product improvement.
Organizations must also be prepared to navigate various challenges associated with this accounting approach, including increased record-keeping complexity and potential distortions in financial metrics.
As businesses weigh these factors against each other to determine if software capitalization is right for them, it is absolutely essential to ensure that they have robust processes in place for accurately tracking capitalized expenses. This allows organizations to maintain transparency about their accounting practices for all stakeholders involved.
Automate Software Capitalization
With an Engineering Management Platform (EMP) like Jellyfish, that manual process becomes automatic by measuring the amount of time engineers spend on specific tasks and projects based on signals from the systems they use. EMPs should be able to provide an auditable measurement of the amount of engineering effort spent on capitalizable projects.
Software capitalization can be a challenging task, but it can also be highly valuable to growing tech companies with significant development investments and future revenue potential.
