Understanding the Capitalization of Software Development Costs

Introduction

Capitalizing on software development costs is a crucial aspect of financial management for tech companies. This blog will explore the intricacies, benefits, and challenges of software capitalization, a practice that allows businesses to manage their finances more efficiently. For companies looking to navigate this complex process, partnering with a software development company can provide valuable expertise and support.

What is Software Capitalization?

Software capitalization refers to the process of recording software development costs as long-term assets rather than immediate expenses. This practice helps companies align the cost of developing software with the revenue it generates, ensuring that expenses are recognized over the useful life of the software rather than all at once.

The purpose of capitalizing software costs is to improve the financial stability and attractiveness of tech companies by spreading the cost over several years, making the company’s financial statements more appealing to investors and stakeholders.

A Comprehensive Guide to Software Cost Estimation and Management: This guide delves into the intricacies of software cost estimation and management, equipping you with the knowledge and resources to navigate the complexities of software project budgets and understand the role of software capitalization.

Applicable Accounting Standards

Adhering to Generally Accepted Accounting Principles (GAAP) is essential for capitalizing software costs correctly. GAAP guidelines help companies determine which costs can be capitalized and ensure consistent financial reporting.

Key Financial Accounting Standards Board (FASB) Account Standard Codifications (ASC) Topics relevant to software capitalization include ASC Topic 350 (Intangibles) for internal-use software and ASC Topic 985 (Software) for external-use software. These standards provide a framework that ensures accounting practices are transparent and consistent across organizations.

In addition, the Statement of Position 98-1 (SOP 98.1), issued by the American Institute of Certified Public Accountants (AICPA), provides specific guidance for accounting for internal-use software development costs.

Understanding Multiple Perspectives on Capitalization

The white paper Understanding Software Capitalization emphasizes the importance of considering different perspectives when making software capitalization decisions. Here’s a breakdown of some key viewpoints:

• Financial Perspective: Focuses on accurately reflecting expenses over time. They view software capitalization as a way to spread the cost of an asset over its useful life.
• Accounting Perspective: Concerned with accurate application of accounting rules. They emphasize that only development costs qualify for capitalization, not ongoing maintenance or post-implementation activities.
• Modern PMO Perspective: Focuses on delivering value while ensuring responsible spending. They advocate for clear cost breakdowns and well-defined capitalization criteria. 
• Product Manager Perspective: Differentiates between customer-facing software (“products”) and internal-use software (“applications”). emphasizing governance and strategic alignment in software capitalization decisions.

Read more: Top 7 Factors That Influence Software Development Cost

When to Capitalize Software Development Costs

Preliminary Stage

During this stage, activities such as planning, conducting feasibility studies, and determining performance requirements are performed. Costs incurred here are treated as expenses, as they do not meet software capitalization criteria.

Application Development Stage

This stage includes design, coding, hardware installation, and testing. Costs incurred during this stage are eligible for capitalization if they meet the necessary criteria. According to SOP 98.1, for internal-use software, capitalization starts after the completion of the preliminary project stage and once management commits to funding the project. For external-use software, software capitalization begins once technological feasibility is achieved.

on if they meet the necessary criteria. According to SOP 98.1, for internal-use software, capitalization starts after the completion of the preliminary project stage and once management commits to funding the project. For external-use software, software capitalization begins once technological feasibility is achieved.

Post-Implementation Costs

After the software moves from development to the operational phase, any costs incurred are treated as expenses. Examples of post-implementation costs include user training, maintenance, and data conversion. These costs do not qualify for software capitalization and are immediately expensed.

Technological Feasibility 

This term refers to the point in the software development cycle where a working model of the software exists. The project must have a clear product vision, and funding, and be in active development. 

Identification in the Development Cycle: Determining this milestone is subjective and may vary between companies. Typically, technological feasibility is reached once initial design and working prototypes demonstrate that the software can function as intended. At this point, companies can start capitalizing on software development costs.

Benefits and Challenges of Capitalizing Software Development Costs

Benefits

• Reduced Impact on Expenses: By capitalizing software costs, companies can amortize or depreciate these expenses over multiple years, lessening the immediate financial burden.
• Amortization and Depreciation Advantages: This accounting treatment improves the appearance of the Profit & Loss (P&L) statement, showing reduced expenses in the short term and spreading the cost over the life of the software.
• Enhanced Financial Stability: Capitalizing software costs contributes to a more stable financial position by reducing immediate expenses, thus making the company appear more profitable.
• Improved Investment Prospects: A stronger balance sheet due to capitalized expenses can attract investors. This practice can also help in securing loans, as lenders often favor companies with better financial health.

Common Challenges

• Limited Timeframe in Agile Projects: Agile methodologies can complicate the software capitalization process due to their iterative nature. The rapid development cycles can limit the periods when costs are eligible for capitalization.
• Complex Accounting Processes: Capitalizing software costs involves intricate accounting practices that require distinguishing between expenses and capitalizable costs, and proper tracking throughout the development lifecycle.

Accurately estimating software development costs is crucial for informed financial planning. Fortunately, there is a tool available to streamline this process Software development cost calculator, offered by Creolo Studios, can be invaluable for tech companies. These calculators help estimate the potential costs associated with a software development project, considering factors like project scope, team size, and development methodology.

Read more: Common Challenges Faced in Software Cost Estimation and How to Overcome Them

Conclusion

Accurate capitalization of software development costs can lead to remarkable financial benefits and stability. By carefully navigating the rules and using tools like software development cost calculator, tech companies can optimize their financial strategies and achieve greater success. By capitalizing costs appropriately, tech companies can present more attractive financial statements, secure better investment opportunities, and manage expenses over the long term. For companies looking to implement efficient cost tracking, a reliable software development company can provide the necessary expertise and tools to manage and capitalize on software development costs effectively.

Business

Bhargav Bhanderi

Director - Web & Cloud Technologies