What is software capitalization?

Software capitalization is an accounting method that companies use to turn certain phases of software development into assets rather than keep them as expenses. The difference between capitalized and expensed means treating certain expenditures as assets with future economic benefits (capitalization), while expenses represent the costs incurred in the ordinary course of business operations.

Capitalized assets are removed from a company's income statement and put on its balance sheet as an asset that can be depreciated. The balance sheet shows what a company owns and owes at a given moment, and the income statement shows the company's financial performance over a specific period. Companies capitalize software to reduce the amount of taxes they need to pay, thereby increasing their profitability. They delay the recognition of these expenses until revenues related to the software being developed are earned.

Not all the costs associated with software development can be capitalized. They must first meet software capitalization rules and criteria. One of these is technological feasibility, which means that a company has completed all planning, design, coding, and testing activities necessary to establish that the product can be produced to meet design specifications. Once this is true, the company can capitalize its software. If a product isn't technologically feasible, the planning, design, coding, and testing costs that were incurred cannot be capitalized. It's important to note that each country has specific tax legislation with its own nuances. A company's executives should understand their legal jurisdiction's tax rules before making decisions on software capitalization.

In general, costs typically capitalized include those related to the software's development, implementation, and testing. This does depend on the type and purpose of the software under consideration. For example, if it will be used internally within a company and not sold to customers, then it's easy to capitalize the costs because this asset won't bring a direct income to the organization. If the software is for external use, meaning the company plans to make a profit on it, then the technological feasibility issue becomes relevant. In this case, planning and design costs can't be capitalized, nor can any costs after the product is available for sale. Only coding, consultation fees, the addition of new features, and salaries can be capitalized.

A company should consider capitalization from both a legal and strategic perspective. As mentioned above, there are criteria for what costs can legally be capitalized. Companies will also want to consider the costs associated with putting off expenses until a later date by considering a product's type and the purposes of the company's activities.

Another challenge is defining technological feasibility. Before, when teams predominantly used the waterfall approach to software development, there were clear stages that made it easy to determine when a product was at this point. Now, under the Agile framework, development is dynamic and ongoing without these clear stages. A way to ensure that the technological feasibility requirement has been met while using Agile is to apply Set-Based Design (SBD) to see when a product is viable, has financing, and when it will be completed.

Software capitalization and amortization describe the same practice of spreading the cost of business assets across a number of years as opposed to reporting them immediately as expenses. The difference lies in the classification of these assets. Strictly speaking, capitalization refers to tangible assets, while amortization refers to intangible assets. Software, however, can be classified as one or the other, depending on how it's used and the benefits it brings to a company. Each country may have its rules for capitalization and amortization, but we can look at the USA as an example. The IRS states that assets must be amortized over a 15-year period. On the other hand, assets can be capitalized over their lifespan.