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Internal-Use Software Capitalization

When a company develops software for its own internal use, it incurs costs related to the development, such as salaries of developers, hardware and software expenses, and other associated costs. The question is whether these costs should be expensed as incurred or capitalized and then amortized over time. Companies can also capitalize external-use software.

Software Capitalization is an accounting practice by which the costs of software R&D are listed as investments instead of expenses. If your company chooses to capitalize some of your R&D costs, they will not be recognized as “losses” immediately on a P&L (profit and loss) sheet, but instead as “assets” on a balance sheet. In this way the costs of, say, developing new software, would be amortized over a period of time.

The decision to capitalize internal-use software costs is typically based on meeting specific criteria outlined in the Generally Accepted Accounting Principles (GAAP) and specifically defined under ASC 350-40. These criteria are:

  1. The software is intended for internal use, such as improving the efficiency of the company’s operations, rather than for sale to customers.
  1. The company is in the application development stage, which typically includes activities like designing, coding, testing, and debugging.
  1. The company incurs costs that are directly attributable to the development of the software. These costs may include salaries of employees directly involved in the development, external consulting fees, and costs of materials and equipment used in development.

If these criteria are met, the company can choose to capitalize the costs associated with internal-use software. Capitalization involves recording the costs as an asset on the company’s balance sheet rather than expensing them on the income statement. Over time, these capitalized costs are amortized (similar to depreciation for physical assets) and charged to the income statement as expenses.

Capitalization of internal-use software can provide several benefits, such as aligning expenses with the economic benefits the software is expected to provide over its useful life, improving financial statement comparability, and complying with accounting regulations. However, it also requires careful documentation and adherence to accounting standards to ensure compliance.

It’s important to note that accounting standards can vary by country and may change over time, so it’s crucial for businesses to consult with their accountants or financial professionals and stay up-to-date with the relevant accounting rules and regulations in their jurisdiction.

Learn about recent clarifications from the IRS on IRC Section 174 for software capitalization and R&D expenditures.

Internal Software Capitalization Benefits

Internal software capitalization provides value for organizations that develop their software applications. As mentioned, capitalization refers to recognizing and recording expenses incurred during the development phase as assets on a company’s balance sheet rather than expensing them immediately. The benefits of this approach include, but are not limited to, enhancing software sustainability and improving DevOps practices.

Capitalization of internally developed software is an accounting method that allows companies to spread out their investment costs over time, which can help improve financial metrics like earnings per share as well as return on assets. Organizations are increasingly adopting this method for the following reasons:

  • To manage technology investments
  • To mitigate risks associated with failed projects
  • To improve overall decision-making around the allocation of resources among competing projects

One key benefit of internal software capitalization is its potential to enhance software sustainability, which refers to the ability of an application or system to continue functioning effectively over time while adapting to new requirements and evolving technologies. When organizations capitalize investments in internally developed software, those investments count as long-term assets that contribute to a company’s future success. This tactic can foster a culture within the organization that places a greater emphasis on maintaining high-quality codebases and ensuring ongoing support for existing applications.

Capitalizing on internally developed software provides opportunities for organizations to invest in strategic areas such as sustainability and DevOps research and assessment. It encourages a comprehensive view of the software lifecycle that goes beyond initial development efforts and promotes better alignment with technology trends, user expectations, and industry best practices.

By adopting this approach to accounting for internally developed software projects, businesses gain significant value by enhancing their competitiveness in an increasingly technology-driven landscape. They can also ensure the long-term viability of their applications and systems.

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.