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Software Capitalization Rules

A few of our tech client companies expressed interest in learning more about software capitalization rules. This is a hot topic in the Seattle tech startup community as companies try to remain compliant and competitive at the same time.

Software For Internal-Use

Internal-use software is treated as a different category under GAAP rules and it represents software tools that will never be sold and are only being developed to be used by internal operations. The table below outlines the project phases and accounting treatment for each phase. Examples of software for internal use are:

  • CRM Tools

  • Accounting Systems

  • Project Management Tools

  • Internal Data Tools

Software For External Use

External use software is intended to be sold after it’s developed, and the GAAP rules are a bit different. First, let’s define the terms listed in GAAP and explain what “intend to sell or lease” or “external use” means. Broadly, these terms include Software as a Service (SaaS) products, or any software product intended to be sold or licensed to external users or customers. Depending on what stage the costs fall under determines if it is expensed or capitalized. Here is an outline:

Benefits of Software Capitalization

When a business capitalizes software, the cost is amortized over time instead of being expensed in the current period. This results in lower reported expenses which leads to higher net income. This approach can be a significant plus for businesses who are interested in adding the software being built as an asset. Usually, software development costs are incurred up front, but the benefits are realized over an extended period of time, usually 3 years. In summary, capitalization better represents the long-term value the software will bring to an organization.

Benefits of Software Expensing

When a business expenses a software purchase or development costs, the amount is then deducted from the company’s net income for the year. Development costs are in most cases tax deductible and this treatment will result in a lower tax liability at the end of the year as a result of reduced profit for the year.

Source: Spark Business Works

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