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Software Capitalization

What is Software Capitalization?

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 argument here is that the cost of that development does not necessarily occur in the same period as when the revenues are earned, and that the cost should therefore be matched up to those future revenues. And if you can prove this direct relationship between costs and future revenues, it’s a good argument (more on that later). For example, if your company spent $1 million in 2023 developing a new application that allows time travelers to visualize the space-time continuum, you might expect to sell a lot of that software once it’s ready in 2024. Therefore, from a business perspective, it might make sense to recognize that $1 million against the revenues that come in throughout 2024 and beyond instead of in 2023 when it was actually spent. By doing so, your company can spread the costs over the useful life of the software, allowing for improved financial reporting and better alignment with the matching principle in accounting.

So, what costs are capitalized for software typically? Often, costs directly attributable to the development, implementation, and testing of the software can be capitalized. Examples might include employee wages, consultant fees, and related travel expenses. It is important to note that costs associated with research, training, and general maintenance are typically not capitalized.

Software capitalization may also enable organizations to better align their financial and operational metrics. By capitalizing costs, companies can align the recognition of expenses with the benefits derived from the software. This practice accurately represents the costs incurred to generate those benefits, supporting better decision-making and performance evaluation. 

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

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Accounting For Software Implementation Costs

Accounting for software implementation costs is a crucial aspect of business financial management. When it comes to implementing new software, various expenses need to be considered. Team members might have questions. For example: can you capitalize ERP implementation costs? Understanding how to account for these costs is essential for accurate financial reporting and decision-making. What’s more, when it comes to capitalizing software implementation costs, IFRS standards and other industry standards can be essential to understand. 

Generally, expenses incurred during the development or implementation phase of software are considered to be capital expenditures. These costs are recorded as an asset on the balance sheet, rather than being expensed immediately. However, the capitalization of software implementation costs is subject to certain criteria. According to the International Financial Reporting Standards (IFRS), the software project must meet specific requirements for costs to be capitalized. These requirements include demonstrating that the software implementation will result in future economic benefits and that the costs can be reliably measured.

It is also important to note that the capitalization of software implementation costs may vary depending on the type of software being implemented. For instance, when it comes to accounting for cloud computing costs, they’re often treated differently than traditional software implementation costs. While accounting for software licenses is such that software licenses are generally capitalized, cloud computing costs are often expensed as incurred due to their subscription-based nature.

Software Capitalization Rules For Internal Use Software

Software capitalization for internal-use software refers to the accounting treatment of costs incurred in developing or acquiring software that will be used solely for a company’s internal operations. The guidelines for capitalizing internal-use software are governed by the Generally Accepted Accounting Principles (GAAP) and specifically defined under ASC 350-40

Internal use software might be treated differently than software that is sold to external customers. This is because software that is sold to external customers is expected to generate revenue, while software that is used internally is typically not.

When it comes to accounting for internal use software and determining whether costs should be capitalized or expensed, there are certain criteria that need to be met. Firstly, the software must be intended for internal use, which means it should facilitate or support the company’s normal business operations, such as payroll processing or inventory management. Additionally, the software should not be primarily intended for sale, lease, or as a product or service to customers.

When it comes to software capitalization, GAAP outlines specific costs that can be capitalized. These typically include external direct costs of materials and services used in developing internal-use software, such as software licenses, consulting fees, and third-party development costs. Additionally, certain internal costs incurred during the application development stage, such as payroll costs directly associated with coding and testing, can be capitalized.

It is important to note that not all costs are eligible for capitalization. Costs related to general and administrative activities, data conversion, data entry, and training are considered to be non-capitalizable. These costs are expensed as incurred. When it comes to understanding purchased software capitalization rules, GAAP can help organizations better understand how to adhere to industry standard accounting practices. 

Software Capitalization Rules For External 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.

Benefits of Software Capitalization

The reason comes down to business valuation. In tech, most companies’ are assigned value by investors based on their revenues or profits. The most common proxy for profits is Ebitda, or earnings before interest, tax, depreciation and amortization, because it generally indicates the profitability of operating the actual business. By capitalizing R&D costs and amortizing them over time, companies remove them from the Ebitda calculation, effectively increasing profits and therefore the value of the company. For startups with significant R&D costs, that could mean a lot for attracting more investor capital needed to grow or for the eventual outcome for any shareholders in an acquisition.

Skeptical? Don’t be. R&D capitalization is a totally legitimate and well established practice. It is accepted under GAAP in the U.S. and the IFRS, the latter of which may actually mandate the practice in certain cases. Across the industry, about 57% of public U.S. software companies capitalize some percentage of their R&D spend, though notables such as Salesforce, Amazon, Workday, and Atlassian capitalize less than 1% of their R&D spend. But why not capitalize more?

Software Capitalization Challenges

As mentioned briefly above, the argument for capitalizing R&D or development costs is a strong one given that you can prove those costs truly relate to future revenues. The problem is that in many, if not most cases, it’s difficult to know for certain which projects will result in future revenues – and how much! – and which will not. Additionally, if your software team is developing more than one product or feature at a time, how do you measure the costs of development for each project in a way that is both accurate and auditable?

To address the first issue, it may take some time and research to develop or use an acceptable framework for valuing and capitalizing intangible assets that are similar to yours. Different industries will do this in different ways, and most industries have analysts and experts that you may need to track down in order to help you out.

Addressing the second issue is not magic, though it may be more labor intensive that you’d care for without the right tools. You could simply keep a detailed spreadsheet which regularly tracks engineering activities, though without being diligent about this or asking engineers to time-log themselves (I wouldn’t suggest that), manually creating an auditable report is a headache at best.

Jellyfish DevFinOps

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. To learn more about Jellyfish and how we can help with software capitalization, visit our website and request a demo today.