Capitalization of software development costs
/Software capitalization involves the recognition of internally-developed software as fixed assets. Software is considered to be for internal use when it has been acquired or developed only for the internal needs of a business. Examples of situations where software is considered to be developed for internal use are accounting systems, cash management tracking systems, membership tracking systems, and production automation systems.
Further, there can be no reasonably possible plan to market the software outside of the company. A market feasibility study is not considered a reasonably possible marketing plan. However, a history of selling software that had initially been developed for internal use creates a reasonable assumption that the latest internal-use product will also be marketed for sale outside of the company.
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Software Capitalization Accounting Rules
If the preceding criteria are present, then the entity can begin capitalizing the cost of software development when both of the following conditions are met:
Management has authorized and committed funding to the software project; and
It is probable that the project will be completed and the software will perform its intended function.
The capitalization of costs may be temporarily prohibited when there is significant development uncertainty. This situation arises when:
A project includes novel or unproven features, and the associated uncertainties have not been resolved through coding and testing; or
The software’s significant performance requirements have not been finalized or continue to be substantially revised.
In the preceding situation, development costs must be charged to expense until the uncertainty is eliminated (after which the capitalization of costs can resume). This approach to cost capitalization keeps an organization from capitalizing the cost of a project that is not stable or technically feasible.
Which Costs to Capitalize
Costs that may be capitalized once the probable-to-complete recognition threshold has been met include only the following items:
External direct costs of materials and services consumed in developing or obtaining the software.
Payroll and payroll-related costs of employees directly associated with and devoting time to the software project.
Interest costs incurred during development.
Costs to develop or obtain software that allows for access to or conversion of old data by new systems.
Which Costs to Expense
Any costs incurred before the probable-to-complete recognition threshold is met shall be expensed as incurred. In addition, the following costs shall be expensed as incurred, regardless of timing:
Training costs
Data conversion costs, except for those enabling access to or conversion of old data by new systems
General and administrative costs
Maintenance costs
When to Stop Capitalizing Costs
If it is no longer probable that a project will be completed, stop capitalizing the costs associated with it, and conduct impairment testing on the costs already capitalized. The cost at which the asset should then be carried is the lower of its carrying amount or fair value (less costs to sell). Unless there is evidence to the contrary, the usual assumption is that uncompleted software has no fair value. The following are general indicators that software is no longer expected to be completed and placed in service:
Expenditures are no longer being budgeted or incurred for the software.
There are programming difficulties that will not be resolved on a timely basis.
There have been significant cost overruns.
The costs that have been or will be incurred significantly exceed the cost of competing third-party software, so management intends to stop development and buy the third-party software.
New technology in the marketplace is driving management to acquire third-party products, rather than completing the internal development project.
The business unit to which the software relates is either unprofitable or will be discontinued.
How to Amortize Capitalized Costs
Once costs have been capitalized, amortize them over the expected useful life of the software. This is typically done on a straight-line basis, unless another method more clearly reflects the expected usage pattern of the software. Amortization should begin when a software module is ready for its intended use, which is considered to be when all substantial system testing has been completed. If a software module cannot function unless other modules are also completed, do not begin amortization until the related modules are complete.
It may be necessary to regularly reassess the useful life of the software for amortization purposes, since technological obsolescence tends to shorten it. The reassessment may also involve consideration of new technology, competing products, and other economic factors.
Benefits of Software Capitalization
The capitalization of software requires some extra accounting activity, but also results in some benefits. These benefits are as follows:
Reduced expense impact. Capitalizing some costs prevents them from being recognized as expenses in the current period, which may allow you to report a profit in the current period, or at least a reduced loss.
Preserves retained earnings. Capitalizing software prevents the current period loss of an excessive amount of retained earnings, which otherwise would have been reduced if the development costs had been charged to expense at once. This gives the business a somewhat more robust financial position, as reported on its balance sheet.
Easier funding. By enhancing the current-period profit picture of the business, it may be easier to obtain funding from the investment community, either in the form of debt or equity.