Capitalizing Software Development Costs: A Crucial Decision

December 14, 2023

When Is Software Capitalized?

Software development costs that are intended to be sold or leased to external users can only be capitalized once technological feasibility is achieved. These costs can include coding and consulting fees from outside collaborators. However, other costs cannot be capitalized, including manual data conversion and training.

Deciding whether to capitalise software development or expense it is a difficult decision. It depends on the rules of your accounting system and the type of software being developed.

Costs incurred during the preliminary project stage

The preliminary project stage is when a company starts planning the development of software. It includes exploratory research, determining the desired functionality of the internal-use computer software, and determining whether technology exists to achieve stated performance objectives. It also includes costs related to interviewing and selecting vendors and consultants who may be able to provide or assist in the development of the new software. Internal costs incurred during this phase, such as employee wages and associated travel expenses, should be expensed.

During the application development stage, a company incurs costs for designing, coding, and testing the software. These costs are typically capitalized if they meet specific criteria, such as being necessary to develop the internal-use software. However, other costs, such as training and data conversion costs, should be expensed.

The decision to expense or capitalize software costs depends on the timing of when a company expects its software to be ready for sale. Some companies, like Google, classify their products as available for sale shortly after technological feasibility is established. Other companies, such as Amazon, prefer to hold off until substantial testing is complete.

Costs incurred during the implementation stage

In general, costs incurred during the implementation stage of software are capitalized rather than expensed. This is because they are expected to provide future economic benefits that can be reliably measured. However, determining which costs are to be capitalized and which to expense can be very subjective. The decision to capitalize or expense software is a matter of choice and can depend on the company’s financial strategy.

Costs that can be capitalized during the development stage of a new software project typically include the following:

Costs incurred during the post-implementation stage

While capitalizing software development costs has its benefits, it can have a significant impact on your company’s financial statements. This is because the cost of capitalizing software is amortized or depreciated over the software’s useful life, and it can be a large portion of your company’s expenses. It can also have a significant impact on your net income. This can be an issue when making big decisions like investment planning or project prioritization.

Capitalizing software development costs can be difficult because of the complexities involved in determining what is eligible. The most common requirements are that management authorize and approve the project, and the product is able to be used for its intended purpose. Other requirements include that a plan of implementation must be developed and management should conclude that the product will be completed and used as expected.

The post-implementation stage is the final phase of the software development process, and it includes all costs incurred after the product is implemented. It usually begins when all testing is complete and the software is ready to be rolled out. The post-implementation stage also includes maintenance and training costs.

Costs incurred during the depreciation phase

If you want to save money on software development costs, it is important to understand when and how to capitalize these expenses. The process of capitalization is similar to the concept of depreciation, and involves spreading a cost over its useful life. However, there are many nuances to this practice, so it’s best to consult an expert accounting firm to handle the granular details.

Typically, only costs that are related to the production of software for external use should be capitalized. This includes the application development stage, which encompasses coding computer software and testing it. The application development phase may also include other costs, such as establishing technological feasibility and research. Once the software reaches this stage, it can be considered ready for sale.

While deciding when to capitalize or expense software costs can be difficult, it is essential for ensuring that financial reports are accurate and consistent. It can also help you make better decisions about how to allocate resources and optimize your development budget.

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