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What Is Software Capitalization?

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Last editedNov 20222 min read

If your business develops its own software for internal use, how do you record its value on your financial statements? Should software licenses be capitalized or expensed? The concept of software capitalization determines how this cost should be dealt with over time. So, what is capitalized software, and how is it treated in accounting? We’ll answer these questions below.

What is capitalized software?

Software capitalization is an accounting procedure that recognizes software development as a fixed asset on a company’s financial statements. Costs are recorded on the balance sheet to delay the expenses recognition, spreading costs out over time rather than incurring a single lump expense. These costs can be depreciated or amortized using the straight-line method across the software’s useful life, typically between two and five years. The benefit of capitalization is that a business can report fewer expenses with a resulting higher net income. This both reduces taxable income and makes the company look more attractive to investors.

The software can be used internally or externally, though the rules of software capitalization will change accordingly. For software to be considered an internal fixed asset, it must be developed or purchased solely for the company’s use. This means it can’t be marketed or sold outside of the business. Common examples include cash management systems, accounting software, and membership tracking platforms.

What are the software capitalization rules?

The software capitalization rules will depend on whether the software is used internally or externally. All accounting procedures should also follow GAAP regulations.

For internal-use software like CRM, production automation, and accounting systems, the product should be treated as a tangible fixed asset.

Record expenses as they’re incurred during the preliminary stage.
During the application development stage, capitalize costs related to activities like testing, programming, and installation. However, any administrative costs like user training or overhead should be treated as expenses rather than capitalized.
During the implementation stage, record any associated costs of the roll-out as expenses. This might include things like software maintenance and user training.

If you’re planning to use the software externally, the software capitalization rules are even stricter. These apply to any software that your company plans to sell or lease to outside parties. The main thing is that all costs should be recorded as expenses rather than capitalized once the project hits the market.

Should software licenses be capitalized or expensed?

You’re planning a new project, so should software be capitalized or expensed? The answer boils down to timing according to the rules above. For most businesses, costs incurred during the preliminary and implementation stages are recorded as expenses. Most costs incurred during the development stage can be capitalized. Capitalization typically ends after the project is complete and the product is used by your team and/or marketed externally.

Here's a rundown of the type of costs that can be capitalized during the development stage.

Payroll costs of the employees directly involved in developing the software
Materials used during the development process as well as travel costs, software purchase fees, and third-party development
Interest fees directly related to sources of funding for the project

If a cost is general or indirect, it should be listed as an expense and not capitalized.

When can you capitalize software?

You can often reap the tax benefits of software capitalization during the development stage according to the rules above. All funding and permissions should be in place, with a high probability that the project will be completed, and software used internally. Capitalization should end if the project is canceled.

Software capitalization shows how IT development and accounting can go hand in hand. As more businesses automate their systems with custom software applications, it’s helpful to choose systems that work well together. GoCardless teams with over 350 partners including accounting and billing software like Xero and Salesforce for a joined-up workflow at every stage.

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