Capitalized Software Development Costs in a SaaS Business

Software development is a critical aspect of running a successful SaaS (Software as a Service) business. Developing high-quality software often comes with significant costs. As a SaaS business owner, it is essential to understand how to manage and account for these expenses effectively. One approach to handling software development costs is capitalization.

In this blog, we will explore the concept of capitalizing software development costs and its implications for SaaS businesses. 

Overview of SaaS Industry Growth

The SaaS industry has experienced remarkable growth, transforming software delivery and consumption. Unlike traditional software with upfront licenses and installations, SaaS delivers applications over the Internet via subscriptions. This shift democratizes software access, benefiting businesses of all sizes.

SaaS companies offer diverse services like CRM, project management, accounting, and HR. Scalability, affordability, and easy deployment attract global entrepreneurs, fostering numerous SaaS startups. 

In this growth, businesses also consider capitalizing on software development costs, including custom software development expenses and outsourcing. 

What is Software Development Costs

Before diving into the details of capitalization, it is crucial to have a clear understanding of software development costs. It typically includes expenses related to designing, coding, testing, and implementing software solutions. These costs can be categorized as either capitalized or expensed, depending on certain criteria.

Capitalizing Software Development Costs

1. What is Capitalization?

Capitalization refers to the practice of treating certain costs as an asset on the balance sheet instead of immediately expensing them. By capitalizing on software development costs, businesses can spread the expenses over the useful life of the software rather than recognizing them as immediate expenses.

2. What is Software Capitalization?

Companies align with Generally Accepted Accounting Principles (GAAP) by practicing software capitalization, which entails recognizing software development expenses over time as the software generates revenue. This process mirrors the accounting matching principle, where expenses align with the period of related revenue recognition.

3. Two Main Methods Available Under GAAP

There are two primary methods for capitalizing software development costs under GAAP:

1. ASC 350-40 (Internal-Use Software)
   This method is typically applicable to software developed for internal use within the organization. It encompasses costs related to preliminary project stages, application development, and post-implementation stages. It’s crucial to follow the guidelines specified in ASC 350-40 to determine which costs can be capitalized.
2. ASC 985-20 (Software to Be Sold, Leased, or Marketed)
   This method is relevant when the software is intended to be sold, leased, or marketed to external customers. It provides specific criteria for capitalization, including establishing technological feasibility, which marks a critical milestone in the development process.

When Can Software Development Costs be Capitalized?

To determine if software development costs can be capitalized, several criteria must be met. These criteria vary depending on accounting standards and rules. But common factors include:

The project must reach a specific stage, such as the completion of a detailed program design or the start of coding.

Establishing technological feasibility involves demonstrating that the software can be developed and operate as intended.

You can reliably identify and measure directly attributable costs, such as development team members’ salaries and software licenses.

The software development has a defined timeframe for completion.

Benefits of Capitalizing Software Development Costs

Capitalizing software development costs can provide several benefits for SaaS businesses:

Improved financial reporting accuracy: By capitalizing costs, businesses can present a more accurate depiction of their financial position, as expenses are spread over the software’s useful life.

Enhanced tax benefits: Capitalized costs can be amortized over time, reducing taxable income and potentially providing tax advantages for the business.

Better decision-making: Capitalizing costs allows businesses to assess the profitability of specific software projects and make informed decisions about future investments.

Factors to Consider When Capitalizing Software Development Costs

 

To determine whether software development costs should be capitalized, several factors should be taken into account:

Project Stage

The project’s current stage significantly influences the determination of whether costs can be capitalized. In general, costs incurred before reaching a specific stage, such as completing a detailed program design, are regarded as pre-production costs and are ineligible for capitalization.

Technological Feasibility

Technological feasibility assessment involves determining whether the software can be developed and function as intended. Once businesses establish technological feasibility, they can capitalize costs incurred from that point forward.

Directly Attributable Costs

Directly attributable costs are expenses that can be specifically identified and measured reliably. These costs typically include salaries of development team members, software licenses, and other expenses directly related to the software development project.

Timeframe for Development

The timeframe for custom software development company is an important consideration. Costs can only be capitalized if there is a defined timeframe for completion. If a project is indefinitely ongoing, it may not meet the criteria for capitalization.

Capitalize vs. Expense Software Costs

One of the fundamental financial decisions that SaaS startups face when accounting for software development expenses is whether to capitalize or expense research and development (R&D) software development costs. Let’s do a comparison of different methodologies and an analysis of the pros and cons.

Should You Capitalize or Expense R&D Software Development Costs?

 

When it comes to R&D software development costs, the decision to capitalize or expense can be a complex one. It’s important to consider various factors before making a choice. 

Factors to Consider:

• Stage of Development: Is the software in the preliminary stage, active development, or post-implementation? Capitalization is generally more applicable in the active development stage when the software is nearing completion.
• Intended Use: Is the software being developed for internal use within the organization, or is it intended to be sold, leased, or marketed to external customers? Internal-use software often follows ASC 350-40, while software for sale follows ASC 985-20.
• Financial Impact: Consider the impact on your financial statements. Capitalizing software development costs can lead to higher asset values and potentially improve your balance sheet, while expensing these costs immediately can result in higher expenses and lower reported profits.
• Tax Implications: Explore potential tax benefits associated with capitalization, such as depreciation deductions that can reduce your taxable income.
  

Comparison of Waterfall Methodology and Agile in Capitalization

The software development methodology employed by your startup can also influence the choice between capitalization and expense. Two common methodologies are the Waterfall and Agile approaches.

• Waterfall Methodology: This traditional, linear approach involves well-defined stages, with each stage completed before moving to the next. If you can attribute the software’s costs to specific stages, such as development and testing, Waterfall may provide better alignment with capitalization.
• Agile Methodology: Agile is known for its iterative and flexible nature, with frequent changes and adaptations throughout the development process. Capitalization in Agile can be more challenging, as expenses may be ongoing and less tied to distinct phases.
  

Pros and Cons of Capitalization vs. Expensing R&D Costs

Let’s examine the advantages and disadvantages of capitalizing on R&D software development costs compared to expensing them.

Pros of Capitalization:

1. Improved Balance Sheet: Capitalizing costs enhances your balance sheet by turning development expenses into assets. This can make your startup appear more financially stable and attractive to investors.
   
2. Revenue Matching: Capitalization aligns costs with revenue recognition, providing a more accurate picture of profitability.
3. Tax Benefits: Depreciation deductions can lead to reduced taxable income and lower tax liability.
   

Cons of Capitalization:

1. Delayed Expense Recognition: Capitalization defers expense recognition, which can temporarily inflate reported profits. This may misrepresent short-term financial performance.
2. Complexity: Capitalization requires adherence to specific accounting standards and ongoing asset management, which can be administratively burdensome.
   

Pros of Expensing:

1. Immediate Expense Recognition: Expensing R&D costs reflects the true immediate financial impact and can provide a clear picture of current financial health.
2. Simplicity: Expense recognition is straightforward and doesn’t require the complexities of capitalization.

Cons of Expensing:

1. Reduced Balance Sheet Appeal: Expensing can result in a weaker balance sheet, potentially affecting your startup’s creditworthiness and perceived financial stability.
2. Potential Tax Disadvantages: Expensing doesn’t offer the same tax benefits as capitalization, which may result in a higher tax liability.

Applying ASC 985-20 and ASC 350-40 for Software Costs

ASC 985-20: “Software—Costs of Software to Be Sold, Leased, or Marketed” guides accounting for the cost of software development intended for sale or lease. ASC 350-40 focuses on internal-use software.

Technological Feasibility and Stages of Development

• Technological Feasibility: Point when software’s core development is done.
• Stages: ASC 985-20 separates custom software development costs and production stages. Expense R&D, capitalize production costs after feasibility.
  

Timing Considerations

• Capitalization Criteria: Costs meeting specific criteria can be capitalized.
• Amortization: Spread capitalized costs over the software’s useful life.

Proper Documentation

• Documentation: Keep records of development stages, feasibility, and rationale for cost treatment.
  

Mastering these standards and capitalizing on software development costs ensures accurate software cost management.

Accounting Treatment of Capitalized Software Development Costs

Amortization and Depreciation

After capitalizing software development costs, businesses amortize or depreciate them over the software’s useful life. This process involves spreading the costs over a specific period, typically based on the estimated revenue-generating potential of the software.

Impairment Testing

Capitalized software development costs may require periodic impairment testing to ensure their carrying value does not exceed their recoverable amount. If businesses identify impairment, they adjust the carrying value accordingly, which could potentially lead to a write-down of the capitalized costs.

Common Challenges in Capitalizing Software Development Costs

Determining the Capitalizable Costs

One of the challenges in capitalizing software development costs is accurately identifying and measuring the costs that can be capitalized. It requires careful documentation and allocation of expenses to ensure compliance with accounting standards.

Compliance with Accounting Standards

Different accounting standards, such as Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS), may have specific requirements for capitalizing software development costs. SaaS businesses must ensure they adhere to the relevant standards to maintain financial reporting accuracy.

Documentation and Record-keeping

Proper documentation and record-keeping are essential when capitalizing on software development costs. Maintaining detailed records of expenses, project stages, and technological feasibility assessments is essential to support the capitalization process.

Importance of Properly Capitalizing Software Development Costs

Financial Reporting Accuracy

Properly capitalizing on software development costs leads to more accurate financial reporting. By spreading costs over the software’s useful life, businesses can present a clearer picture of their financial position and performance.

Tax Benefits

Capitalizing on software development costs can provide tax advantages for SaaS businesses. By amortizing the costs over time, taxable income can be reduced, resulting in potential tax savings.

Improved Decision-making

Capitalizing costs allows businesses to evaluate the profitability of specific software projects. This information enables informed decision-making regarding future investments in software development.

Outsourcing Software Development and Capitalization

Cost of Outsourcing Software Development

Outsourcing software development is a common practice in the SaaS industry. When considering capitalization, it is important to understand the costs associated with outsourcing. These costs may include fees paid to external development teams, project management expenses, and any other directly attributable costs.

Capitalization Considerations for Outsourced Projects

When outsourcing software development, the same principles of capitalization apply. Businesses must ensure that the outsourced project meets the criteria for capitalization, such as reaching the required project stage and establishing technological feasibility.

Conclusion

Capitalizing Software Development Costs is a strategic approach for SaaS businesses to manage expenses and improve financial reporting accuracy. By understanding the criteria for capitalization and complying with accounting standards, businesses can make informed decisions and potentially benefit from tax advantages. Proper documentation and record-keeping are crucial for successful capitalization. Whether a SaaS business develops software in-house or outsources the development, capitalizing software development costs can contribute to long-term financial success.

Frequently Asked Questions

Q1. Is it possible to capitalize all software development costs?

Capitalizing all software development costs is not possible; they must meet specific criteria.

Q2. How long you can amortize capitalized software development costs?

Typically, companies amortize capitalized software development costs over their estimated useful life.

Q3. What happens if a capitalized software development cost becomes impaired?

If a capitalized software development cost becomes impaired, the company may adjust its carrying value downward.

Q4. Are there any specific accounting standards for capitalizing software development costs?

Yes, there are specific accounting standards, such as ASC 985-20 and ASC 350-40, for capitalizing software development costs.

Q5. Can I capitalize on software development costs if I use an agile development approach?

Yes, you can capitalize on software development costs when using an agile development approach if they meet the capitalization criteria.