Capitalisation of Software development Cost

Software capitalization involves the recognition of internally-developed software as fixed assets. Software is considered to be for internal use when it has been acquired or developed only for the internal needs of a business. Further, there can be no reasonably possible plan to market the software outside of the company. A market feasibility study is not considered a reasonably possible marketing plan. However, a history of selling software that had initially been developed for internal use creates a reasonable assumption that the latest internal-use product will also be marketed for sale outside of the company. 

When to Capitalize Costs

Any allowable capitalization of costs should begin after the preliminary stage has been completed, management commits to funding the project, it is probable that the project will be completed, and the software will be used for its intended function.

Conditions to capitalize:

In order to be able to capitalize software development costs, the software being developed has to be eligible based on certain criteria prescribed under GAAP. Broadly speaking, there are two stages of software development in which a company can capitalize software development costs:

• The application development (i.e. coding) stage for software intended for a company’s internal use.

• The stage when “technological feasibility” is achieved for software that will be sold or marketed to the public.

1. Software capitalization rules for internal-use software

Preliminary stage: During the preliminary stage, companies record costs as incurred. These types of expenses involve 

• decision-making about the allocation of resources, 

• discussions about performance requirements, 

• supplier demonstrations and selections and 

• assessments of technology.

Application development stage: During the application development or coding stage, companies can capitalize the costs related to 

• programming, 

• hardware installation and testing, such as employee payroll, 

• third party development fees, 

• software purchase costs, 

• interest costs and 

• travel costs related to development work. 

As for general and administrative costs like 

• data conversion, 

• user training and overhead, 

companies record these expenses as incurred.

Implementation stage: During the implementation stage, companies record costs as incurred. This is the phase in which the software is live and in use, and costs may involve training and maintenance.

2. Software capitalization rules for external-use software

Preliminary stage: During the preliminary stage and before the software is technologically feasible, companies expense costs as incurred. This stage involves activities to understand the goals for the product’s features, like 

• research, 

• initial project planning, 

• prototyping and 

• design work.

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Technologically feasible stage: Technological feasibility of a software product occurs when the organization has completed all planning, designing, coding and testing activities and a design or working model is ready for customer testing. Costs involve 

• coding, 

• testing and 

• labor costs,

 and companies can capitalize on these expenses.

Available for sale stage: Once a software product meets technical performance requirements and is available for sale and release to customers, a company starts recording expenses as incurred. The remaining costs involve 

• maintenance and support, 

• error correction, 

• troubleshooting and discovery.

When to Cease Capitalization:

The capitalization of costs should end when all substantial testing has been completed. If it is no longer probable that a project will be completed, stop capitalizing the costs associated with it, and conduct impairment testing on the costs already capitalized. The cost at which the asset should then be carried is the lower of its carrying amount or fair value (less costs to sell). Unless there is evidence to the contrary, the usual assumption is that uncompleted software has no fair value.

Benefits of capitalizing software

Capitalized software is capitalized and then amortized instead of being expensed. This will result in lower reported expenses and therefore higher net income. Note that the decision to capitalize for GAAP purpose does not necessitate doing the same for tax purposes. As a result, companies looking to show higher net income for book purposes would prefer to capitalize software costs.

Conclusion

Because of the subjectivity about determining the software development phases of internal use and commercial software, it is important to understand differences in these accounting decisions when comparing software companies. Two identical software companies might have very different looking financials based solely on this accounting decision.

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