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Understanding the Capitalization of Software Development

December 28th, 2022
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Software capitalization means treating your development related costs as long-term assets rather than expenses for the duration of a product’s development phase. This entails putting these costs on a balance sheet, rather than as incurred and delaying the moment when they become an expense that’s taxable. This will have an impact on your P&L (Profit & Loss or general income statement) and make your net income bigger over a period of time – a feature that is attractive to investors. 

But not all costs involved in software development can be capitalized because they need to meet certain criteria. This is regulated under the Generally Accepted Accounting Principles (GAAP) that is a standard for the US. Understanding when you can capitalize your software expenditures as assets enables you to generate more profit, scale your business and accelerate time to market.

Waydev, can offer you a set of features that help you keep track of your costs. This will give you a better understanding of resource planning and an overview over your expenses. Having a good grip on your project costs can enable you to make better decisions on where you can apply software capitalization methods. 

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What Is Software Capitalization?

Software capitalization refers to a method of recognizing software engineering costs over a longer period of time, and treating them as assets, instead of registering them as expenses as soon as they’re incurred. Usually, an accountant puts these costs on the income statement, and they become taxable expenses. 

In a tech organization that produces software, you need to spend money for each step – from ideation to software development.. But how do you treat these costs from an accounting perspective and what is the difference between capitalizing and expensing them? Here is a brief overview and term definition: 

Software Costs That Qualify for Capitalization

When considering capitalizing software within your company, the first step is to understand this practice falls under strict rules based on GAAP – these tell you which costs you can submit as assets and not immediate expenses. But not all costs that can be capitalized should be – this relates to financial strategy and what’s best for your company depending on a number of factors. 

It’s very important to understand when you should capitalize your costs and when to treat them as expenses – from both a legal and strategic point of view. Here is the breakdown to help you understand when software costs can be capitalized over a period of time, depending on the product type and its purpose in your company practices. 

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Software Developed for Internal-Use Only

Software Developed for External-Use

Criteria for Development to Qualify for Capitalization

The original practice of software capitalization under the US GAAP guidelines fell under the Waterfall method that meant a certain sequential order of development. This is how software was historically developed in the past, and it implied a very specific order of developing a product, making it easy to identify the phase of a product.

The main steps with the Waterfall approach are – analysis/ plan, system design, development/ code writing, testing, release, and maintenance. Each step had to be executed in this order and solved before progressing to the next stage. The accounting method for rendering costs as assets and thus capitalizing them was based on this particular practice. 

But nowadays, software development has evolved and a different approach has emerged – the Agile approach. This new model entails cutting each step of the development process into smaller sections of activity. It also means getting through the steps faster and involving end-users in the process much sooner, for early feedback in testing the product. This way you can understand whether a product functions or not, what are the issues and points you can improve. 

The Agile method brings a more flexible approach to software, with development teams organized on specific tasks or products, and that translates into faster results and better communication with end-users. The challenge with this method comes from the accounting side of things – how do you translate software capitalization based on GAAP methods for the new way of developing software, when the rules were made to fit the previous Waterfall approach? 

The answer to this particular question is no easy task, nor is the actual application in practice. Keep in mind that for products meant for public release, only costs in the development stage are up for capitalization, according to the GAAP rules. With the Waterfall approach, it was very easy to identify the cost that qualified for capitalization because each step was clearly defined. 

The challenge with the Agile method comes from its more dynamic approach – some tasks are solved individually, then integrated into the main project, while others go through sprints – a fast and intensive way to get things done.  

But this leaves room for interpretation – how do you know for sure whether a particular activity and its corresponding cost falls under the technological feasibility stage or it’s still in the preliminary analysis phase? 

Set-base design is one way of ensuring that technological feasibility has been met. This tells you the product is doable, has financing, and will be completed – this is when you can start capitalizing costs. With projects that fall under the Agile method, this can sometimes be challenging because set-based design can lead to unplanned work that may increase project costs. Our Executive Reports help you identify and report these costs while reducing unplanned work by 21%.  

What Are the Benefits of Software Capitalization?

Software capitalization is a practice derived from standard accounting methods (GAAP) which allow certain advantages for your company while developing products. Please keep in mind that they may also present some challenges. Here are the main benefits of using software capitalization within your company:

Software Capitalization Challenges

While software capitalization has its benefits, this practice may also bring on some confusion and hidden ”side effects”. Here are some key points to understanding where this potential pitfalls lie: 

Deciding what costs qualify for capitalization is difficult and requires many discussions and planning of resources. This is true especially for projects developed under the Agile Method, as explained above in this article, because the lines between different project stages are more blurry.

Applying Software Capitalization to the Agile Method

Software capitalization can provide advantages for your company’s net income through amortization or depreciation of costs. While these fall under strict GAAP rules and must be thought out carefully, the practice can play an important role in your company’s financial situation, if done correctly. 

Waydev can be of help when navigating through the intricacies of choosing what costs you can capitalize instead of expensing. By using our resource planning feature, you can keep track of how your costs are allocated through the duration of a project and decide what stage of the product development phase they fall under. 

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