There are two types of software that are developed for a business: 1) internal-use software, and 2) software developed to be sold, leased or marketed (“software to be sold”). The accounting and capitalization requirements for these two different types of software is very different. Here is a high-level comparison of how each type of software is capitalized. For internal use software, there are three stages defined by accounting guidance: 1) preliminary project phase (i.e. planning, evaluating alternatives, conceptual formation); 2) application development (i.e. design, coding, integration with hardware), and; 3) Post implementation phase (i.e. testing, maintenance). The capitalization of costs should start after the preliminary project phase, and is contingent on management committing to funding the continued development of the software, and the completion of the project being probable. Costs should cease to be capitalized after the project is substantially finished (generally, close to the start of the post implementation phase). All costs outside of this capitalization window should be expensed as incurred. The costs qualifying for capitalization are also restricted, but that is a whole blog unto itself.
For software to be sold to third parties, the accounting guidelines are completely different. Accounting guidance requires that costs associated with the development of software to be sold are charged to expense as incurred, until the point in which technological feasibility has been established. Technological feasibility is established once an entity has completed planning, designing, coding, and testing the software to ensure that the software will work for its intended function. As a general guideline, sometimes technological feasibility is considered established once software enters beta testing. Capitalization must cease when the software is ready for general release to customers. Accordingly, the window for capitalization is extremely small, and often, startup companies expense all costs during development.
Based on the above highlights, internal-use software generally carries a higher asset value on the balance sheet of companies than software to be sold (assuming the costs incurred to develop both are the same).
If your startup is developing software, it would be wise to contact an accounting consultant with software accounting experience to review which category your software falls into and what costs qualify for capitalization, if any. In addition have your CTO track and document the progress of the project. The accountant will need to line up expenses with the progress of the project to correctly account for the software.
dbbmckennon is a full service CPA firm with offices in Orange County and San Diego focused on providing quality accounting and consulting services at reasonable rates. For additional complimentary information regarding this topic or other questions you may have please call one of dbbmckennon‘s offices located in Southern California or contact us here.