Software capitalization: A guide for engineering leaders

Software capitalization is an accounting practice focused on recording the cost of developing software as an asset. While it might seem like a concept only for the accounting department, understanding the software capitalization process gives engineering leaders a better handle on managing resource allocation while creating an improved developer experience for their entire team.

In this guide, we'll review software capitalization in detail and why engineering leaders should understand the process. We'll also explore the benefits for your team, when you should capitalize software, and challenges you may need to tackle along the way.

Table of contents

• What is software capitalization?
• The benefits of software capitalization
• The rules of software capitalization
• When to capitalize software
• 5 capitalization challenges and solutions
• FAQ

Part of IT budgeting, software capitalization is the process of recording software development costs as assets rather than traditional expenses. This method spreads these costs out on a balance sheet rather than recording them as expenses all at once. Development costs may include personnel, infrastructure, licenses, testing, maintenance, and operations.

Software capitalization can benefit accounting teams by allowing them to report higher net incomes in the short term, positively impacting reported financial performance. For accounting, it can also result in better monetary returns and more straightforward statements.

The core of the software capitalization process is recording costs as assets rather than expenses. When a company expenses software development costs, it registers them as expenses within a given period. Companies may choose to expense software with short lifespans, items that don't match capitalization criteria, and research and development costs that don't result in developed software. You can capitalize R&D costs if they directly contribute to the development of your software product.

Software capitalization can positively impact a team's ability to innovate; this is the critical reason you should advocate for it as a technical leader. Becoming involved with these accounting practices can help you shape a better environment for your developers and team members. Here are four benefits of the capitalization process and how they can improve your leadership strategy.

• Enhanced decision-making: Leaders can make more informed decisions about team staffing and software prioritization by using the data and insights that come with software capitalization.
• Optimized resource allocation: Recording development costs as assets allows companies to invest more in their engineering teams by planning and accessing additional resources and tools.
• Improved culture of innovation: Software capitalization helps establish a culture where you foster innovation and address immediate financial concerns for leaders.
• Improved developer experience: Financial and development teams can better align by capitalizing on software costs, giving engineering leaders more autonomy and allowing them to focus on creating high-quality software. This process can also result in additional resources for long-term project support. Additionally, this approach creates a more efficient and rewarding work environment that can lead to increased job satisfaction.

You can't capitalize all of your software development costs; rules and laws state what type of software your team can capitalize, with a particular focus on internal vs. external software. We'll explore the differences between internal and external software and provide a breakdown of basic software capitalization accounting standards within the United States. 

It's critical to check with your accounting department on software capitalization, as laws are subject to change, and your organization may need to follow additional local or state accounting practices.

Internal software development costs are expenditures your company may incur when developing software for its own internal use. These standards are set within the Accounting Standards Codification (ASC) 350-40. In general, costs during the application development stage are capitalized following these rules:

• The software must be technically feasible to develop.
• The company must intend to complete its software development project.
• The software must be designed for either use or sale.
• Any costs must be directly attributed to the development.
• Costs before development, such as planning and design, are excluded.
• Costs after implementing the software, such as maintenance, are excluded.

External software development costs are expenditures your company may incur when developing software for sale or lease to others. These standards are set within the ASC 985-20. In general, external costs are capitalized only during the technological feasibility stage. Once outside this stage, the software is typically expensed. External software follows these rules:

• The software must be technically feasible to develop.
• The company must intend to complete its software development project.
• The software must be designed for either use or sale.
• Any costs must be directly attributed to the development.
• External software can only be capitalized during the feasibility stage.
• Costs after, including distribution and customer support, are excluded.

The rules of software capitalization are clear, but you might not want to capitalize everything just because you can. Engineering leaders should know when to advocate for software capitalization to create a better developer experience and open doors to additional innovation practices. Opt for software capitalization when the software:

• Is a part of a strategic initiative that needs additional time before reaching its full potential
• Involves significant innovation or research that needs time to be implemented
• Will provide long-term benefits, such as reduced costs or additional revenue streams
• Has a chance to boost team morale by showcasing company commitment to its development team

In contrast, you should avoid software capitalization if your project is for short-term purposes, contains high risks of failure, or has expectations of routine maintenance.

Capitalizing software can come with its own set of challenges. From understanding potential audit risks to determining useful software lifespans, there are multiple obstacles to proper capitalization processes. Luckily, team leaders can overcome these challenges with careful self-analysis and planning.

Estimating the useful lifespan of a piece of software can take time and effort. To appropriately capitalize software, you must consider different factors, including technological advancements, business needs, and industry standards. 

Solution: Continually reassess the software's lifespan and consider a more conservative approach to avoid the risk of overstating an asset’s value. You may also employ testing to recognize any potential decline in your software's value.

When capitalizing software, you need to determine whether the software is internal or external. Failure to properly categorize software can negatively impact financial statements, affect tax deductions, and lead to misinformed decisions.

Solution: Establish clear criteria with your company's accounting team to help differentiate the differences between each option. Collaborate and seek guidance if any complex classification issues occur to avoid any possibility of miscategorization that could have adverse effects, such as audits, down the road.

As mentioned, miscategorizing capitalized software can lead to audits that can lead to serious tax liabilities and penalties. Incorrectly categorizing software can also lead to accurate financial reporting with the risk of misleading stakeholders.

Solution: Keep detailed documentation of software development costs, resources, and time spent. Work with your accounting department to stay up-to-date on any additional accounting standard changes or updates to tax regulations that affect software capitalization.

With technological changes rapidly advancing, your software can quickly be classified as obsolete or outdated. If this occurs, the value and lifespan of your software will be affected. 

Solution: Focus on continuous learning within your team, allowing developers to adapt to the latest technologies. To keep up with the fast pace of developments, your team might consider adopting an Agile development practice to respond quickly to changes.

Software development documentation has always been a critical issue, but we aren't just talking about commenting code this time. It’s best to implement robust time and expense tracking as your team progresses through its software development pipeline. 

Solution: Work with your team to create standardized documentation procedures and consider conducting regular reviews to ensure compliance. Also consider summarizing and consolidating the sum of your expenses using MySQL.

The Pluralsight team has worked to deliver top-notch software development education and tools for two decades, so we know a thing or two about the process. Here are a few of the most frequently asked questions about software capitalization.

No, your software does not need to be capitalized, but it’s a good idea to consider how it could benefit your team and organization. Consider capitalizing software when it meets set criteria to improve financial performance, encourage innovation, and create a better developer experience for your team. Discuss software capitalization with your accounting department to learn more about the right time to capitalize your software.

How long to capitalize on a piece of software depends on multiple factors, including how quickly it will become outdated, current business needs, and ongoing maintenance costs. The most typical capitalization periods are from three to five years; this period is known as amortization. Regularly review your software's estimated lifespan and assess its value with your accounting department to help with your decision-making.

Many costs can be capitalized throughout the software development process; it’s best to consult with your accounting department to ensure compliance with your current procedures. In general, some capitalization costs include:

• Consulting fees
• Overhead costs
• Personnel costs
• Software development tools
• Software licenses

Yes, you can capitalize SaaS software development costs, but they must meet the criteria within ASC 350-40. Note that capitalized costs typically occur during the application development stage. The software's cloud-based nature may affect the product's lifespan, so be sure to evaluate it closely.

Software capitalization can have an immensely positive impact on your development team, but knowing how to evaluate those changes manually can be challenging. Using software such as Pluralsight Flow, you can gain more significant insights into potential changes while simplifying your reporting process with software engineering metrics. 

Request a demo today and discover how Flow can help drive efficiency within your team.