Capitalizing software is difficult but rewarding for any company.
- However, the amount capitalized and the differences between IFRS and US GAAP depend on whether a ‘business’ or a single asset/group of assets is acquired. Under US GAAP, only IPR&D acquired in a business combination is capitalized post-acquisition. The definition of a business is an area of change under both US GAAP and IFRS.
- All research phase costs should be expensed. The following development phase costs should be capitalized: External direct costs of material and services consumed in developing or obtaining internal-use software; Payroll and related costs for employees who devote time to and are directly associated with the project; Interest costs incurred while.
It's a process that allows accountants to present business finances more accurately, but it can be a complicated and challenging task to pull off.
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It's very easy for an accounting department to miss projects that should be capitalized. Software engineers may start developing a project without notifying accountants, and by the time accountants are aware of the project, it may be too late to capitalize expenses.
But even when accountants know about capitalizable projects, it’s a complex, manual process that leaves lots of room for error. Fortunately, capitalizing software expenses doesn't have to be difficult. In this article, you'll learn:
- The rules of software capitalization
- How software is capitalized today
- An easier way to capitalize software expenses with automation
Armed with this knowledge, you and your business will never struggle with missed software projects and inaccurate data during the accounting process again.
What is software capitalization?
In accounting, software capitalization is the process of recognizing in-house software as fixed assets. Accountants accomplish this by recording software costs on the balance sheet as capital expenses. Then, accountants can amortize these costs over time.
The ultimate purpose of capitalizing is to delay fully realizing an expense. If a company incurs expensive software costs, the company’s income will appear abnormally low during that period. However, if the accounting team can capitalize the software, the company can distribute the software’s cost over several years.
Essentially, it will look like the company is paying off the software as the business uses it over time. This provides a more accurate assessment of company finances, both to the business and to outside investors.
As long as the in-house software meets eligibility requirements, businesses may capitalize the following:
- Computer software developed for internal use
- Hosting arrangements obtained for internal use, e.g. using a Software as a Service (SaaS) vendor
- Website development costs
Some examples of software developed or acquired for internal purposes include:
- Project management systems
- Collaboration software
- Software for on-boarding
- Reporting or ticketing systems
Following GAAP and IFRS
Software capitalization is a powerful tool for company finances. However, there are strict guidelines and practices for capitalizing expenses, and it’s in a business’s best interest to keep these standards.
In particular, accountants should follow either the Generally Accepted Accounting Principles (GAAP) or The International Financial Reporting Standards (IFRS). Pre IPO and public software companies need robust tracking to be compliant with GAAP accounting standards ASC 350 and/or ASC 985.
These standards and principles provide consistency in a company’s financial statements and in financial reporting across multiple companies. This allows investors to analyze company finances with more fairness and transparency.
GAAP is the accounting protocol issued by the Financial Accounting Standards Board (FASB). It includes the best practices and authoritative standards adopted by the U.S. Securities and Exchange Commission and is used across the United States. You can access FASB’s Accounting Standards Codification online (requires registration fee).
Outside of the United States, businesses follow the International Financial Reporting Standards (IFRS). IFRS is issued by the International Accounting Standards Board (IASB). You can access IFRS’s standards online too (requires registration fee).
Fortunately, FASB and IASB are working together to converge their respective standards. Currently there are differences between GAAP and IFRS, but this article will focus on adhering to GAAP when capitalizing software.
When software is eligible for capitalization
A company can capitalize software if it’s designed for company use and there are no plans to market it. First post!eagle browser.
The Financial Accounting Standards Board summarizes these two requirements in ASC 350-40. In order to classify software as in-house, it must meet the following characteristics:
- The software is acquired, internally developed, or modified solely to meet the entity’s internal needs.
- During the software’s development or modification, no substantive plan exists or is being developed to market the software externally.
A company may conduct a market feasibility study on the software and still meet the requirements.
Accountants can determine a new project’s eligibility by answering the following questions:
- Has management committed to funding the project?
- Is it likely the project will be completed?
- Is it likely the software will be used for its intended purpose?
If the answer to all of these questions is “yes” then accounting should plan to capitalize the in-house software.
Please note that the rules for capitalizing any company property still apply to software. For example, the software must be expected to benefit the business for longer than one tax year to qualify as a fixed asset.
Which costs should be capitalized
The easiest way to capitalize all the appropriate costs is to first identify three stages in the software’s life: the preliminary stage, the development stage, and the post-implementation stage.
By identifying when these stages begin and end, you can be confident you’re capitalizing all the appropriate costs.
Stage 1: Preliminary
In this stage, your company is still just planning to use in-house software. Do not capitalize any costs in this stage.
Costs in this stage include company time spent on:
- Considering developing an in-house software vs. using a third-party software
- Determining the system requirements for the software
- Deciding who will work on the project and for how long
Stage 2: Development
During the software development stage, some costs should be capitalized, and some costs should not be.
The following development costs should be capitalized:
- Costs of materials and services in developing or obtaining the software (for both internal and external resources)
- Payroll and bonuses for employees who worked on the project
- Interest costs on loaned money used to develop the software
The following development costs shouldnot be capitalized:
- Overhead costs
- Costs for data conversion
- Training costs
If your business is using a Software as a Service vendor, FASB revised ASC 350-40 to provide guidance on capitalizing software in a cloud computing arrangement that is a service contract.
However, FASB summarized their position by instructing accountants to follow the same policies used to capitalize software that was developed in-house. (This rule is effective for businesses beginning in 2020).
Stage 3: Post-implementation
At this stage, the software is up and running for the entire company. You do not capitalize any costs in this stage, including:
- Operating costs
- Repair and maintenance costs
- Fixing bugs or minor issues
In short, you do not capitalize costs in the preliminary or post-implementation stage. In between the two, during the development stage, you capitalize the materials and services it took to develop the software.
There is one exception to this rule, however. If your business performs a significant upgrade to the software post-implementation, you can capitalize the costs for the upgrade. Accountants can determine if the upgrade is significant by answering the following questions:
- Does the upgrade add functions that the software previously couldn’t perform?
- Do the engineers classify the upgrade as significant?
- Can you easily distinguish upgrade costs from maintenance and minor enhancement costs?
If the upgrade is eligible for capitalization, you can capitalize the same costs mentioned in the development stage.
When amortization begins
Amortization begins at the start of the post-implementation stage.
Amortization for capitalized software does not begin with testing or trial runs. Instead, amortization begins once the software is placed in service throughout the company and can perform its intended function.
In the case of a hosting arrangement, capitalized expenses are amortized over the term of the agreement.
When estimating the useful life of software, consider that technology becomes outdated quickly. In some cases, an appropriate useful life expectancy can be as low as 3 to 5 years.
How software capitalization is currently done
Today, accountants usually capitalize software manually. Here’s what the process typically looks like:
First, accountants ask product managers and engineering managers to fill out data on new projects that may be eligible for capitalization. This data is manually entered into a spreadsheet, Google Sheet, or Airtable.
The product manager and engineering manager then fill in information by estimating how much time each worker spent on different projects during the most recent period.
Accountants then ask the payroll team to provide compensation and salary data for all impacted employees. Then accountants multiply the time spent on the project by the payroll numbers.
The product of this calculation is the total value of the capitalized software in that period. Once accountants acquire this number, they move this amount from the operating expenses line on the income statement to the capital expenditures line on the balance sheet.
Disadvantages to Manual Software Capitalization
The current manual approach is a necessity for many businesses, but it opens up unnecessary opportunities for error, waste, and frustration for accountants and managers. Here are some of the pitfalls of capitalizing software expenditures manually.
1. Manually capitalizing is tedious and time-consuming
Entering information into a spreadsheet is monotonous and eats up company time. In some cases, managers have to spend valuable time just finding the correct information before they can begin entering the data.
2. Manually capitalizing is inaccurate
When entering a lot of data into a spreadsheet, there will invariably be errors. Managers roughly estimate the time employees spent on projects. Sometimes they simply forget which employees worked on which projects and for how long.
Additionally, typos are common and it’s easy to enter information in the wrong field. When you put these factors together, you end up with inaccurate results.
3. Manually capitalizing means missed projects
Sometimes engineers do not communicate to accounting that they started new projects. In some cases, significant time passes before the accounting team is aware of a capitalizable project.
In short, capitalizing software manually is difficult and unreliable. Fortunately, there will be another option in the future.
How software capitalization will be done in the future
In the future, with GitBloom, accountants will be able to capitalize software programmatically. This solves many of the common problems that companies face when capitalizing software costs.
With GitBloom CapEx software, accountants will be able to manage the software capitalization process automatically. Here are just a few of the powerful features that accountants will have access to with GitBloom.
1. Detect new projects in the preliminary stage
Engineering managers and product managers often start new projects without communicating with the accounting department. Now, whenever software developers create a new microservice, file, or module, Gitbloom will automatically notify accountants.
This can spur accountants to chat with engineering managers and product managers to determine whether or not the new project is eligible for capitalization. Accountants receive these notifications in real-time, ensuring that accounting departments never miss a new capitalizable project again.
2. Detect when a project is in the development stage
GitBloom plugs into your company’s signals, metrics, or logging systems and detects when engineers start developing the software. This means accounting immediately knows when workers begin developing a project and who in the engineering department is in charge.
3. Measure where engineers spend their time
Accountants can determine which engineer has worked on which project by inspecting lines of code. GitBloom records pull requests, commits, and pushes for every service, file, and module. All of this can be done in real-time.
This allows accountants to measure how long each engineer has spent on each project. Then, accounting can discuss measurements with an engineering manager or product manager to determine where to allocate engineering time.
4. Calculate the software value
GitBloom pulls measurement data from your company’s Git repository. This includes:
- Azure DevOps (TFS)
- GitHub and GitHub Enterprise
- Google Cloud, and more
GitBloom can also pull salary data from your company’s payroll system, including programs like Workday, Gusto, BambooHR, and more
By combining the repository and payroll data, GitBloom can estimate the value of capitalization. Accounting teams can then make adjustments based on other input to arrive at the final value of software capitalization in a given period.
Accountants can then pull and share a report of all this information with auditors to corroborate how they arrived at the capitalization value.
Automation is the future of software capitalization
Capitalization Of Purchased Software
In the future, accounting and finance functions will be automated with software solutions like GitBloom. Finances will be easily auditable and fully trackable. With GitBloom, accountants will be able to..
- Never miss a project eligible for capitalization
- Track where and when workers contributed to software development
- Easily pull data on work time and salary
- Accurately calculate the value of capitalization
Increase productivity, simplify your workload, and help your business succeed with an easier way to capitalize software.
IFRS and US GAAP
IFRS does not address software development costs directly and some IFRS interpreters actually take the position that costs associated with internally developed software should not be capitalized. However, IFRS states that management may consider more recent “pronouncements of other standard-setting bodies that use a similar conceptual framework to develop accounting standards” and therefore it is possible to argue that best practice under IFRS might be to consider pertinent US GAAP.
US GAAP is very explicit in terms of accounting for software development costs (expensed versus capitalized). “
Capitalization Of Software Gaap
- Internal and external costs incurred during the preliminary project stage shall be expensed as they are incurred.
- Internal and external costs incurred to develop internal-use computer software during the application development stage shall be capitalized.
- Costs to develop or obtain software that allows for access to or conversion of old data by new systems shall also be capitalized.
- Training costs are not internal-use software development costs and, if incurred during this stage, shall be expensed as incurred.
- Data conversion costs, except as noted in paragraph 350-40-25-3, shall be expensed as incurred.
- Internal and external training costs and maintenance costs during the post-implementation operation stage shall be expensed as incurred.”
For ERP Projects, and in our case as a Microsoft Partner these are typically Microsoft Dynamics AX, Microsoft Dynamics NAV, or Microsoft Dynamics CRM projects, the service costs associated with an implementation are subject to the accounting rules above. Software licenses should be capitalized. So license costs associated with the aforementioned products (Axapta, Navision, and Microsoft CRM) can be capitalized unless they are purchased under a SAAS pricing model (Software as a Service); in this case they should be expenses as incurred.
If you need help understanding the accounting implications associated with the costs of your software/ERP project, let us know and we can help implement a process for tracking your project’s costs that will comply with your audit requirements. We can help you implement a work breakdown structure (WBS) that is aligned with the accounting rules so that you are consistent with how you capitalize and expense software project costs.
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