Do you capitalize the cost of software development?

June 4, 2008 10:03 AM

Does your company capitalize the cost of software development? Why or why not?

Just because I'm curious. If you work for a software company specifically, does your firm capitalize the cost of software development or do they expense it. Are there any plain language (i.e. "non-account) reference materials out there that would explain the pros and cons of each approach?

posted by dhacker to technology (7 comments total)

It's funny but having worked in software my entire life I actually do not know. I am going to guess and say they expense it because they were all small companies that were 100% based on software revenue and capitalized nothing. Even servers were leased essentially converting one of the few capital expenses to an operating expense. Most small companies seek to avoid capital expenses as much as possible (in my experience). Primarily because they lack capital.

Certainly you can check the 10K's for various publicly-traded pure software companies and see what they do.
posted by GuyZero at 10:09 AM on June 4

I don't currently work for a commercial software development company so I can't give you a literal answer. I remember studying some software companies as a class assignment in business school many years ago and realizing that some very profitable companies like Lotus (at the time) and I think Microsoft were not capitalizing their software development. I don't know if that's still the case. Basically the reason you would capitalize software development would be to make your current assets and profit margins appear to be greater than they would be if you were to expense it. It's an interesting gray area of accounting that presumably most investors would be aware of when evaluating the worth of a company.
posted by thomas144 at 11:23 AM on June 4

Did you try Google also? because this is the first thing it brings up: "CAPITALIZATION OF SOFTWARE DEVELOPMENT COSTS: A SURVEY OF ACCOUNTING PRACTICES IN THE SOFTWARE INDUSTRY," for the query "capitalize software development cost".
posted by GuyZero at 11:34 AM on June 4

Pros of capitalizing R&D costs:
- Higher operating profits in the current period
- Better alignment of R&D costs and revenue later generated from those efforts

Cons:
- If you capitalize and then amortize R&D costs for tax purposes, you're delaying the tax benefit. If you expensed your costs right away, the present value of the tax benefit is greater.
- Investors may think you're engineering or smoothing our earnings.

It's common for investors to look at companies both ways--with R&D capitalized and with it expensed. If a company has an inconsistent policy regarding capitalization and switches back and forth without good reason, it's generally seen as earnings manipulation. On the other hand, capitalizing R&D may allow for a more nuanced analysis of a company's economic profits (versus accounting profits).
posted by mullacc at 11:36 AM on June 4

First you have to differentiate between research and development of software as a product for sale and software developed for internal use (for example your company's sales management software or accounting software). R&D is a business expense while the latter is an asset like a piece of machinery purchased for internal use. In the U.S. R&D must be expensed. Software development for internal use is capitalized if it amounts to more than $100,000 and has a useful life greater than two years.

In general, it is advantageous to expense because it means you can take the entire deduction in the current year. If you capitalize, you must amortize and spread the deduction over a period of years.

This is explained in American Institute of Certified Public Accountants’ (AICPA) Statement of Position (SOP) Number 98-1, Accounting for Costs of Computer Software Developed or Obtained for Internal Use. For a start see this.
posted by JackFlash at 12:01 PM on June 4

I should clarify, that in the U.S. R&D must be expensed for IRS and tax purposes. For SEC required balance sheets, R&D can sometimes be capitalized.
posted by JackFlash at 12:04 PM on June 4

Expensed, everywhere I've worked.
posted by polyglot at 11:38 PM on June 4