It determines whether a product can meet its intended requirements have been completed. When capitalizing software development costs, you must meet specific criteria, understand which costs to capitalize vs. expense, and when to do either. The accounting gets especially complicated when the organization delivers software through a hybrid of cloud and on-premises infrastructure. This is because an entity will need to identify development activities that are dedicated to the cloud environment, which may need to be accounted for differently from the activities that enhance the on-premises technology. On top of that, the accounting team may lack visibility into a few vital pieces of information needed to properly identify and account for development costs. One of those pieces is when functionality is no longer available for on-premises deployment (which could be the case when new functionality is only available in the cloud).
To be for internal use, the software must have been acquired or developed only for the internal needs of a business. These software costs are then capitalized on a company’s balance sheet instead of being expensed as incurred. The conventional waterfall development approach involves organizing a project into a series of traditional phases, such as conception, initiation, analysis, design, construction, testing, production and implementation, and maintenance.
For software that the organization will deliver as a service, on the other hand, much of the development cost will likely have to be capitalized. Although these guidelines seem straightforward enough, the timing of a shift from on-premises to cloud delivery may not always be clear. Set-base design is one way of ensuring that technological feasibility has been met.
The accounting for internal-use software varies, depending upon the stage of completion of the project. These materials were downloaded from PwC’s Viewpoint (viewpoint.pwc.com) under license. However, this article should serve as a guide to familiarize you with the concept and examples of how companies use capitalization to an advantage.
The critical point to remember is that in order to assess the costs that should be capitalized, there needs to be sufficient project planning to demonstrate that the criteria for a “detailed program design” have been met. The risk is that project teams may not do enough front-end planning or retain adequate documentation to demonstrate they have met this threshold. Demonstrating technological feasibility is likely to require the project team to do more planning and compile more documentation than is typical in most agile projects. Under an agile model, on the other hand, a project is organized into separate modules, and the development and testing work on these modules is done in short sprints. Identifying when the traditional activities of the waterfall approach occur requires significant analysis and judgment in agile development, which can make it more difficult to apply GAAP guidance for capitalizing expenses. Organizations can also hit a snag when determining costs related to identified enhancements.
Applying GAAP in an agile environment
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. But nowadays, software development has evolved and a different approach has emerged – the Agile approach.
When an agile team develops functionality into production, they may or may not have created a new asset that the organization should start amortizing. It depends on whether the team intends to build on their work in a subsequent sprint. If the new asset really is complete, that means other costs may have to be abandoned or impaired, and it’s not always clear which costs get what kind of treatment. All of this can make it hard to properly identify and capitalize costs in an agile environment. The main steps with the Waterfall approach are – analysis/ plan, system design, development/ code writing, testing, release, and maintenance.
Waterfall approach
In many cases software is typically available to be sold or leased to the public as they reach the stage of “technological feasibility” and as such any costs accumulated from this point onward must be expensed as incurred. Examples of software whose costs can be capitalized include accounting and customer management systems, cash management tracking systems, membership tracking systems, production automation systems, etc. that are unlikely to be for public use. In the following table, we give a proper overview of the advantages and disadvantages of capitalizing software development costs. 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. The methods technology companies use to develop new software for their customers have changed in recent years, making applying the rules for capitalization of software development cost more challenging. Capitalization of software development costs involves a lot of judgment and estimation. Our team of experts is available to support you and ensure the right calls get made. You must accomplish two key milestones before you can capitalize on your software development costs. The original practice of software capitalization under the US GAAP guidelines fell under the Waterfall method that meant a certain sequential order of development.
Understanding the Capitalization of Software Development
The waterfall approach was commonly used to manage software development projects in the past. For external use software costs incurred after technological feasibility is obtained may be capitalized. The “technological feasibility” stage includes all planning, coding, and testing activities.
- Note that the decision to capitalize for GAAP purpose does not necessitate doing the same for tax purposes.
- This process involves collaboration between the accounting and development teams.
- We capitalize certain costs related to the development of athenaNet services and other internal-use software.
- DTTL and each of its member firms are legally separate and independent entities.
Under the internal-use software rules, development costs generally can be capitalized after the end of the preliminary project stage. The threshold for software development costs for external sale or licensing — the focus of this article — is more stringent, which means more analysis is required to determine which development costs should be capitalized. The primary challenge to tracking software development costs for capitalization is tracking development time related to specific projects and phases. Most startups don’t have an adequate process in place for allocating time to each stage of development.
Applying Software Capitalization to the Agile Method
In many cases, the specific facts and circumstances surrounding the type of software being developed will drive the treatment of costs. Careful planning can aid in the analysis of which costs to capitalize versus expense. GAAP outline capitalization requirements based on the waterfall approach (see the “Waterfall Approach” chart), in which activities happen in a specific sequential order.
- GAAP outline capitalization requirements based on the waterfall approach (see the “Waterfall Approach” chart), in which activities happen in a specific sequential order.
- Finally, once development is complete and the software is made available for release to customers, capitalization no longer is appropriate because any remaining costs are considered ongoing maintenance and support.
- As a SaaS company leader, your expertise probably lies in your product field, not accounting practices.
- At this point, GAAP requires capitalizing eligible development costs of the internal-use software.
- The reason for this article on capitalizing software costs for startup founders is educational.
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. Amortizing software costs as described in the previous paragraph is done through a company’s income statement and as such reduces expenditure and increases income.
Why SaaS Fractional CFOs Are Game-Changers for Startups
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. Ultimately, both the agile and waterfall models can produce a successful project; however, determining the point in the software development process to begin and end capitalizing costs can be more challenging with the agile model.
Certain services may not be available to attest clients under the rules and regulations of public accounting. For the most part, as a business owner who wants to take advantage of the benefits of capitalizing costs, you will need to employ an expert accounting firm to handle the granular details not covered here. Generally speaking, software is only capitalized if it is perceived to be revenue-driving for a startup. And even then, only parts of the cost that makes up the total cost of the software can be capitalized according to the accepted accounting principle. Similarly, the decision to classify internally used software as in the development stage vs. the implementation or project stage can also be subjective. With nearly 10 years of accounting experience, Audit Manager Katie Owen specializes in compilations, reviews, and audits, with experience in managing employee benefit plan audits, from the planning stages to issuance.
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. For an example of core software development costs that can be capitalized, see the following sections. One set of rules (FASB Accounting Standards Codification (ASC) Topic 985, Software) is designed for software costs that the entity intends to sell or lease. These rules, commonly referred to as the software capitalization rules for external-use software, are the primary focus of this article.
Changes should enable the software to perform tasks it was previously unable to perform. Generally, guidance for internal use software results in more capitalized costs than external use software. It is appropriate to capitalize costs when the project receives funding and is likely to be completed.
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.
