Capitalizing Software Development Costs: Best Practices and Benefits

We are living in a highly software-driven world where companies are heavily investing in the development of innovative applications. However, how such development costs are accounted for could prominently impact a company’s financial outlook. Keeping this on note, this blog will address the concept of capitalizing software development costs, mentioning the best practices, and stating the potential benefits.

Note that this blog is an excellent read for those who are looking towards capitalization of software development costs for external use and already have some knowledge regarding capitalizing software development costs.

Useful advice: After reading this, if you need more information regarding capitalizing software development costs, then contact FuturByte. They are a globally recognised custom software development company that will offer you helpful informational aid.

Expense versus Capitalize in Software Development Costs

The below-mentioned table is a summary of the essential differences between capitalizing and expensing software development costs:

When to go with Capitalizing Software Development Costs

Capitalization refers to the treatment of an expense as an asset. When applied to software development, this means the disbursement of development costs over the software’s useful life and not expensing the entire cost at once.

Capitalization spreads the costs over the software’s lifespan. This will result in a much more balanced financial picture.

As per the Generally Accepted Accounting Principles (GAAP), software development costs can be capitalised in two key scenarios. We will look at them in some detail below, but first, if you need more information regarding capitalizing software development costs gaap, contact FuturByte. They are a reputed LMS software development company that will provide you with excellent information.

Let’s go back to the scenarios:

Scenario I: Internal Use Software

Meeting the Capitalization Criteria: If you want to go with the capitalization of software development costs for internal-use, the software must meet specific criteria, which is:

• It is identifiable as a separate asset
• It is internally developed
• It is expected to offer probable future benefits
• It incurs prominent development costs

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Identification of Capitalizable Costs: Not every internal development cost qualifies for capitalization. Some of the most common capitalizable costs include:

• Third-party development fees
• Salaries alongside benefits of development team members
• Hardware and software-related costs used for development
• Implementation and testing costs

If you are having difficulties identifying capitalizable costs, then it will be best for you to have a thorough discussion with your company’s prominent internal stakeholders.

Scenario II: Software for External Sale

The Attainment of Technological Feasibility: Any software utility being developed for external sale can be capitalized after it attains the “technological feasibility” factor. This is the stage that highlights that a software’s basic functionalities have been both crafted and showcased to work.

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Capitalizing Software Development Costs: Best Practices

Any company that wants to ensure a proper degree of capitalizing software development costs should follow the below-mentioned best practices:

Establishment of Clear Procedures and Policies: Companies should develop a clearly understandable internal policy that outlines the overall capitalization criteria for software development projects. The purpose of this policy should be to define the capitalization process, which costs qualify, and the documentation-related requirements.

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The Implementation of a Reliable Cost Tracking System: It is highly important to track every development cost accurately. This is where a reliable accounting system will allow you to categorise costs as expensed or capitalized, paving the way for a good reporting activity.

Keeping a Thorough Documentation: Keep thorough/detailed documentation for every capitalised software project. This is often considered to be one of the best elements of capitalizing software development costs. This includes justifications for capitalization decisions, cost breakdowns, and development plans.

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Benefits Associated with Capitalizing Software Development Costs

There are a host of advantages presented by capitalizing software development costs to organisations. Let’s look at them in some detail here:

Better Financial Reporting

Decreased Expense Fluctuations

When development costs are spread over a certain time, capitalized software goes on to decrease the impact on short-term expenses. This will allow a more stabilised financial outlook.

Increased Net Income

Capitalization will allow you to recognise expenses in a gradual manner. This will increase the reported net income in the beginning years of software utilisation.

Better Project Management

Capitalizing software development costs requires careful cost tracking and planning. This will harness a highly disciplined approach to software development project management.

Innovation Encouragement

Today, many IT industry experts are of the opinion that capitalization allows organisations to perform investments in long-term software development projects with the knowledge that costs will not have a huge impact on the existing financials. This can encourage more innovation.

Of course, when it comes to innovation, it is always wise for your organisation to stay a step ahead of its competition. If you need more advice on this matter, feel free to contact FuturByte today. They are a business management software solutions provider that will offer you wonderful advice on the matter.

Considerations and Challenges

It is now established that capitalizing software development costs offers a host of benefits. Still, it is important to state here that there are a prominent number of considerations and challenges associated with it. Let’s look at some of these:

The Effect on Taxes

It is possible that tax regulations differ from accounting standards associated with software development cost treatment. This is why companies should try to consult a tax advisor, as it will allow them to better grasp the potential tax implications.

Proper Amortisation

The costs of capitalized software are amortized throughout their useful life. This is why the selection of an appropriate amortization schedule is highly important for precise financial reporting.

Looking at Some Advanced Considerations

This blog has discussed the core principles of software development cost capitalization. Now, let’s take a look at some additional considerations that are best suited for complex scenarios:

Various Development Stages: The software development process commonly involves a host of phases. This is why it is common to see that companies choose to capitalize on costs after attaining particular milestones, like achieving a minimum viable product (MVP) stage.

Open Source Software: It is commonly seen that using open-source components can bring in complexity. The costs related to integrating or modifying open-source elements can qualify for capitalization. This qualification depends on the associated modifications and their effect on the functionality of the software.

Possible Future Sale vs. Internal Use: Let’s say that there is a case in which an organisation develops software for internal usage. Later on, it decides to sell the software. Here, the capitalization treatment could require some adjustments to showcase the purpose-related change.

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Concluding Remarks

Capitalizing software development costs can act as a highly beneficial strategy for those organisations that are looking to invest in long-term software development projects.

If organisations follow the best practices as stated in this blog, they will be able to enjoy the benefits of enhanced project management, improved financial reporting, and a higher degree of flexibility for innovation.

However, it is important to take into account the impact of taxes and determine amortization schedules.

It will be best for organisations to consult a financial professional since this will allow them to get help with navigating the particulars of software development cost capitalization. Additionally, the consultation will ensure that there is optimal financial reporting of the organisation.

Finally, if you need more informational assistance with any of the points discussed in this blog, contact FuturByte. They are a renowned ERP software development services provider that will be of great assistance to you.

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