The process of capitalization or expensing when developing or purchasing software is an advantage most businesses don’t know they have. The process provides an opportunity for businesses to reflect the cost of software in the way that most benefits their organization and financial goals.
A growing number of companies are investing in software applications for both their business and customers. While many who don’t handle finances are not familiar with the difference between expensing and capitalizing, it is vitally important to the financial health and operation of any company that is building or buying software. When software development or purchase costs are capitalized, those costs become added to a company’s balance sheet instead of being recorded as an expense. When building software, businesses have a few ways to add the cost of the process to their financial statements, either by expensing or capitalizing.
If a business decides to add software development costs as an expense, it is added to their income statement and subtracted from their yearly profit. However, if the business decides to capitalize some of the cost, that means the cost will become added as an asset to the company’s balance sheet. A good way to determine what to expense versus what to capitalize is by referring to Generally Accepted Accounting Principles (GAAP).
What is GAAP?
The term “GAAP” means Generally Accepted Accounting Principles. GAAP is designed to implement consistency in a company’s financial statements. Using GAAP is almost industry standard and means investors and outside parties (like lenders) can easily compare, contrast, extract and report on the financial information of an organization. Moreover, if a business is publicly traded, then it is required to use GAAP. GAAP provides guidelines that help businesses decide which software development expenses should be capitalized or expensed.
An Example of Capitalizing and Expensing Software Costs
To illustrate, a construction company may spend $200,000 on the development of a new piece of software. The software is expected to streamline operations and improve overall income. However, taking $200,000 in expenses doesn’t accurately represent the gain the company is expected to incur. To more accurately portray the value the new piece of software will bring as an asset versus the cost, the finance team–finding that the cost was in coding and development–decides that 60% of the expense can be capitalized over a 5-year period using GAAP. This decision will show $80,000 of costs for the year (instead of $200,000) and $120,000 of capitalization. The result is the current year profit, and loss is impacted less, to the tune of $80,000, and the remaining $120,000 is amortized or depreciated over the next five years.
“Whether to expense or capitalize depends on the client, as some organizations want to reduce taxable income for the year for various reasons,” said Bob Armbrister, CEO/President, SPARK Business Works. ”A company may say they want to expense a project this year because they want to reduce taxable income. With others, maybe they are owned by private equity or VC (venture capital), or they are trying to maximize Earnings Before Interest, Taxes, and Amortization (EBITA). Using capitalization or expensing allows flexibility, as we see clients do different things based on what they’re experiencing in the marketplace. If they are sitting on cash, they may pay for software upfront. In other cases, they are managing it to an EBITDA number and they will spread it out and capitalize,” Armbrister stated.
Using capitalization or expensing allows flexibility, as we see clients do different things based on what they’re experiencing in the marketplace.
When To Capitalize
In the example above, a portion of the cost is deferred because the software being built is going to be an asset, thus providing value to the company at a later date. However, not all software costs should be capitalized and added to the balance sheet. Deciding between capitalization or expensing can be challenging, but there is a specific list of cost types that are eligible based on rules outlined in the GAAP.
Typically, financial teams who are deciding to capitalize or expense divide assets into two groups:
- Assets that DO produce value at a later date.
- Assets that DO NOT produce value at a later date.
Meaning, during the course of software development, different stages and types of software are handled differently. This fact also means that depending on the kind of software development methodology used, different phases are either expensed or capitalized accordingly. A bit of freedom may be realized when it comes to what can be expensed or capitalized because it’s up to the business to decide when the software is either in the “feasibility phase,” the “development,” or “coding” stage.
A bit of freedom may be realized when it comes to what can be expensed or capitalized
According to John Orlando, CFO, Centage Corporation,“Based on GAAP, software can be capitalized if it is purchased to serve the internal needs of the company. Typically, it encompasses a perpetual software license that is purchased one time and can be used indefinitely.” Software that falls into this category includes custom management, operations, or production systems that benefit internal operations of a company.
According to The Journal Of Accountancy, there are various types of software development processes covered under GAAP. The most common software development model outlined in GAAP is referred to as the “waterfall approach.” This term means there are sequential steps that software development follows, and depending on what step a cost was incurred, will determine if it is expensed or capitalized. These steps also change if the software is being developed for internal use or external use.
Software For Internal-Use
The software capitalization rules for internal-use software category in GAAP outline the process for tools that will never be sold and are only being developed to be used by internal operations.
Examples of software for internal use are:
- CRM Tools
- Accounting Systems
- Project Management Tools
- Internal Data Tools
Software For External Use
For software intended to be sold after it’s developed, the process is a bit different. First, let’s define the terms listed in GAAP and explain what “intend to sell or lease” or “external use” means. Broadly, these terms include Software as a Service (SaaS) products, or any software product intended to be sold or licensed to external users or customers. Depending on what stage the costs fall under determines if it is expensed or capitalized.
Benefits of Software Capitalization
When a business capitalizes software, the cost is amortized on their balance sheet instead of being expensed on the Profit and Loss (P&L). This means lower reported expenses which leads to higher net income on the P&L statement. This process can be a huge plus for businesses who are looking to add the software being built as an asset. Usually, software development costs are incurred up front, but the benefits are realized over a more extended period. So in this case, adding the software as an asset makes sense. In summary, capitalization better represents the long-term value the software will bring to an organization.
Benefits of Software Expensing
When a business expenses a software purchase or development costs, the amount is then deducted from the company’s income for the year. If costs are expensed in this case, it will result in a lower tax bill at the end of the year as a result of reduced profit for the year.
Outcomes of Capitalization and Expensing Compared
“This decision is a cherry on the top. Most clients don’t realize they have these options. Most organizations have already decided they are getting the software, and then learn about capitalization and expensing at the end of the process. The fact that they have choices on how this reflects on the financial reports is an added bonus,” concludes Armbrister.