What is Software Capitalization?

Stepping into an engineering leadership role often comes with unexpected responsibilities, like working closely with finance on software capitalization. Sure, you might not have envisioned dissecting software development costs as part of the job, but it turns out to be a crucial task. Understanding and implementing software capitalization is vital for your company's financial health and can significantly boost its value.

It's a common area where people feel out of their depth. However, mastering this aspect is key to driving business success. In this article, we'll dive into the essence of software capitalization, shedding light on why it's an important piece of the puzzle you should definitely pay attention to.

What is Software Capitalization?

Software capitalization is an accounting practice for software and its development process as an investment rather than a cost of expenditure for the business. This applies to software built by a company for both internal and external use. Software capitalization helps consider software as an intangible asset, thereby assisting in reducing taxable income. Reporting fewer expenses for a company results in higher net income. Capitalizing software development for financial accounting procedures has never been new and has been practiced since 1985.

Perks of Capitalizing your Software

Software capitalization is a process derived from accepted accounting principles to enable businesses a certain set of financial advantages. Here are some of the beneficial aspects of adopting software capitalization:

1. Capitalizing software development can help a company reduce its expenses and cash flow by adopting amortization (paying off debts in installments for intangible assets) or depreciation (paying off debts in installments for tangible assets).
2. Software capitalization enables a company to save on taxes allowing them the advantage of spreading out the cost of software development over the years.
3. It assists the business to benefit from an increased asset value.
4. Software capitalization helps list out the software development costs as an investment on the balance sheet rather than the company’s income statement saving expenditure and building a better net income value in the market.
5. Saving money on taxes also enables businesses to invest in other prioritizing software projects, hires, and outside consulting that translate into a profitable business.

Hurdles posed by Software Capitalization

As its benefits, software capitalization comes with its own set of pitfalls. Here are a few of them:

1. While taking into consideration the size of certain projects, its time of development is quite fast. In such cases, the window to pay off software development expenses is limited and there would not be any recruitment for software capitalization. This means software and its development cannot always be considered as an asset, they have their limitations.
2. Software development projects that have been capitalized may seem to give the illusion that a huge sum of money has been saved. But in reality, the time frame of those software costs has been expanded. As it takes a long time to be paid off, the cost spent on the software to be visible in the overall net income is also expanded.
3. Maintaining a balance sheet, the company’s income statement along with a profit and loss statement can sometimes become confusing.
4. With the Agile method of developing software, sometimes it is hard to decide which part of the software development procedure must fall under capitalization.

Guidelines for Software Capitalization

Generally Accepted Accounting Principle (GAAP) highlights numerous accounting rules and standards to be followed while considering processing software for capitalization. It pinpoints the set of rules to abide by while checking what type of software and at which particular development phase it qualifies for software capitalization. These accounting guidelines help in understanding which costs can be submitted as assets. GAAP standards for software capitalization provide companies with a financial strategy depending on various factors.

It is vital to understand when to treat your costs as expenses and when to treat them as an investment when it comes to understanding software capitalization. According to the GAAP, the legal standpoints for capitalizing software used for internal purposes follow a different set of regulations when compared to capitalizing software used for external purposes.

Software Capitalization for internal use software (ASC 350-40)

Internal-use software refers to the tools that are used within the company for productivity, keeping track of accounts, customer data, accounting, customer management, automation, etc. These are strictly built for the employees only and are classified as tangible assets of the business. Companies can only capitalize on new software or new functionalities that are added to the existing software. The rest is to be incurred as expenses. Once the decision-making phase of building software is done, the development phase begins. Companies can capitalize on the expenses spent during this stage as an asset. All costs related to the development of the software, such as hardware installation, third-party development fees, software purchase, etc. can be deemed as an investment and be capitalized by the company.

Software Capitalization for external use software (ASC 985-20)

External-use software is the one that can be purchased by customers from the company. They are for sale in the market. Capitalizing external use software differs from capitalizing internal use software and follows a bit more rigid rules according to GAAP. The preliminary project stage involves understanding the goals and features of the software, software project planning, prototyping, etc. The software is developed using code and all the expenses that are incurred in this stage can be capitalized by the organization. After the completion of the software, the sales of the software to the customers in incurred as expenses by the company.

When to Capitalize a Software?

Capitalizing software is normally done after the preliminary stage of software development when the initial planning is done. It begins during the second phase, which is the development or the coding stage, and usually ends before the completion of the software. Software can be capitalized for the following reasons according to GAAP :

1.  To match costs with the revenue spent by the organization.

2. To generate accurate financial reporting and maintain a proper track of the expenses and investments of the company. This enhances transparency in financial statements.

3. To gain long-term economic benefits as the software gains recognition over time.

4. To stay in compliance with accounting standard boards such as GAAP, and IFSR while reporting software development costs.

5. To enhance the company's reputation and confidence by regulating its financial health and decision-making.

Factors to Consider when Capitalizing a Software

Initially, software capitalization fell under the Waterwall model of software engineering. This method has a sequential flow to it and the company can easily identify the development phase of the software. This is the phase in which the development of the software is supposed to be capitalized according to the GAAP and International Financial Reporting Standards (IFRS) guidelines. But, with the evolution of software engineering, the Agile model of software development came into play.

The Agile model provides a faster and more flexible approach to developing software. It helps in better communication with the end-users. With the Waterfall approach, it is easy to identify the software development expenses that qualify for capitalization, as its steps are clearly defined. On the other hand, the Agile method is a dynamic approach, that integrates certain phases to provide quick results by directly collaborating with the clients through sprints. Hence, spotting the development phase to capitalize the software is a challenge. This is where two factors are considered. They are:

Technological feasibility

Determining if the software can be developed in the intended manner and if it will function in the desirable cause it was developed for is referred to as technological feasibility. Once this is determined, it becomes clear as to what is to be capitalized during the development of the software.

Directly attributable expenses

These are the cost allocations that can be specifically identified and measured to ascertain the reliability of the software. For example, expenses that include the salaries of the developers and software licenses.

Exercising Software Capitalization for Agile Method

Software Capitalization is a strategic approach for businesses to manage their capital expenditure and enhance their financial account maintaining processes with accuracy and transparency. Organizations are to critically understand the accounting standards and regulations that help save on taxes. This enables companies in decision making giving them the advantage of both saving huge amounts of money on expenses by converting them to investments. Capitalizing software and a particular phase of the development process contribute to long-term financial benefits for organizations.