Ifrs Capitalization Of Software Projects

Capitalizing software is difficult but rewarding for any company.

Ifrs Software Capitalization Rules
Capitalization Of Purchased Software
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International Financial Reporting Standards (IFRS) PwC Contents 71. Presentation of capitalised development costs 76 72. Recognition of raw materials as inventory 77 73. Pre-launch inventory produced before filing 78 74. Treatment of inventory of ‘in-development’ drugs 79 75. Treatment of inventory of ‘in-development’ generic drugs 80 76. Types of arrangements. Software as a service (SaaS) includes a wide range of arrangements providing web-based delivery of applications managed by a third-party vendor. Platform as a service (PaaS) involves a third party providing a framework for a team of software developers to create and manage customized applications. Infrastructure as a service (IaaS) involves a third.

It's a process that allows accountants to present business finances more accurately, but it can be a complicated and challenging task to pull off.

It's very easy for an accounting department to miss projects that should be capitalized. Software engineers may start developing a project without notifying accountants, and by the time accountants are aware of the project, it may be too late to capitalize expenses.

But even when accountants know about capitalizable projects, it’s a complex, manual process that leaves lots of room for error. Fortunately, capitalizing software expenses doesn't have to be difficult. In this article, you'll learn:

The rules of software capitalization
How software is capitalized today
An easier way to capitalize software expenses with automation

Armed with this knowledge, you and your business will never struggle with missed software projects and inaccurate data during the accounting process again.

What is software capitalization?

In accounting, software capitalization is the process of recognizing in-house software as fixed assets. Accountants accomplish this by recording software costs on the balance sheet as capital expenses. Then, accountants can amortize these costs over time.

The ultimate purpose of capitalizing is to delay fully realizing an expense. If a company incurs expensive software costs, the company’s income will appear abnormally low during that period. However, if the accounting team can capitalize the software, the company can distribute the software’s cost over several years.

Essentially, it will look like the company is paying off the software as the business uses it over time. This provides a more accurate assessment of company finances, both to the business and to outside investors.

As long as the in-house software meets eligibility requirements, businesses may capitalize the following:

Computer software developed for internal use
Hosting arrangements obtained for internal use, e.g. using a Software as a Service (SaaS) vendor
Website development costs

Some examples of software developed or acquired for internal purposes include:

Project management systems
Collaboration software
Software for on-boarding
Reporting or ticketing systems

Following GAAP and IFRS

Software capitalization is a powerful tool for company finances. However, there are strict guidelines and practices for capitalizing expenses, and it’s in a business’s best interest to keep these standards.

In particular, accountants should follow either the Generally Accepted Accounting Principles (GAAP) or The International Financial Reporting Standards (IFRS). Pre IPO and public software companies need robust tracking to be compliant with GAAP accounting standards ASC 350 and/or ASC 985.

These standards and principles provide consistency in a company’s financial statements and in financial reporting across multiple companies. This allows investors to analyze company finances with more fairness and transparency.

GAAP is the accounting protocol issued by the Financial Accounting Standards Board (FASB). It includes the best practices and authoritative standards adopted by the U.S. Securities and Exchange Commission and is used across the United States. You can access FASB’s Accounting Standards Codification online (requires registration fee).

Outside of the United States, businesses follow the International Financial Reporting Standards (IFRS). IFRS is issued by the International Accounting Standards Board (IASB). You can access IFRS’s standards online too (requires registration fee).

Fortunately, FASB and IASB are working together to converge their respective standards. Currently there are differences between GAAP and IFRS, but this article will focus on adhering to GAAP when capitalizing software.

When software is eligible for capitalization

A company can capitalize software if it’s designed for company use and there are no plans to market it.

The Financial Accounting Standards Board summarizes these two requirements in ASC 350-40. In order to classify software as in-house, it must meet the following characteristics:

The software is acquired, internally developed, or modified solely to meet the entity’s internal needs.
During the software’s development or modification, no substantive plan exists or is being developed to market the software externally.

A company may conduct a market feasibility study on the software and still meet the requirements.

Accountants can determine a new project’s eligibility by answering the following questions:

Has management committed to funding the project?
Is it likely the project will be completed?
Is it likely the software will be used for its intended purpose?

If the answer to all of these questions is “yes” then accounting should plan to capitalize the in-house software.

Please note that the rules for capitalizing any company property still apply to software. For example, the software must be expected to benefit the business for longer than one tax year to qualify as a fixed asset.

Which costs should be capitalized

The easiest way to capitalize all the appropriate costs is to first identify three stages in the software’s life: the preliminary stage, the development stage, and the post-implementation stage.

By identifying when these stages begin and end, you can be confident you’re capitalizing all the appropriate costs.

Stage 1: Preliminary

In this stage, your company is still just planning to use in-house software. Do not capitalize any costs in this stage.

Costs in this stage include company time spent on:

Considering developing an in-house software vs. using a third-party software
Determining the system requirements for the software
Deciding who will work on the project and for how long

Stage 2: Development

During the software development stage, some costs should be capitalized, and some costs should not be.

The following development costs should be capitalized:

Costs of materials and services in developing or obtaining the software (for both internal and external resources)
Payroll and bonuses for employees who worked on the project
Interest costs on loaned money used to develop the software

The following development costs shouldnot be capitalized:

Overhead costs
Costs for data conversion
Training costs

If your business is using a Software as a Service vendor, FASB revised ASC 350-40 to provide guidance on capitalizing software in a cloud computing arrangement that is a service contract.

However, FASB summarized their position by instructing accountants to follow the same policies used to capitalize software that was developed in-house. (This rule is effective for businesses beginning in 2020).

Stage 3: Post-implementation

At this stage, the software is up and running for the entire company. You do not capitalize any costs in this stage, including:

Operating costs
Repair and maintenance costs
Fixing bugs or minor issues

In short, you do not capitalize costs in the preliminary or post-implementation stage. In between the two, during the development stage, you capitalize the materials and services it took to develop the software.

There is one exception to this rule, however. If your business performs a significant upgrade to the software post-implementation, you can capitalize the costs for the upgrade. Accountants can determine if the upgrade is significant by answering the following questions:

Does the upgrade add functions that the software previously couldn’t perform?
Do the engineers classify the upgrade as significant?
Can you easily distinguish upgrade costs from maintenance and minor enhancement costs?

If the upgrade is eligible for capitalization, you can capitalize the same costs mentioned in the development stage.

When amortization begins

Amortization begins at the start of the post-implementation stage.

Amortization for capitalized software does not begin with testing or trial runs. Instead, amortization begins once the software is placed in service throughout the company and can perform its intended function.

In the case of a hosting arrangement, capitalized expenses are amortized over the term of the agreement.

When estimating the useful life of software, consider that technology becomes outdated quickly. In some cases, an appropriate useful life expectancy can be as low as 3 to 5 years.

How software capitalization is currently done

Today, accountants usually capitalize software manually. Here’s what the process typically looks like:

First, accountants ask product managers and engineering managers to fill out data on new projects that may be eligible for capitalization. This data is manually entered into a spreadsheet, Google Sheet, or Airtable.

The product manager and engineering manager then fill in information by estimating how much time each worker spent on different projects during the most recent period.

Accountants then ask the payroll team to provide compensation and salary data for all impacted employees. Then accountants multiply the time spent on the project by the payroll numbers.

The product of this calculation is the total value of the capitalized software in that period. Once accountants acquire this number, they move this amount from the operating expenses line on the income statement to the capital expenditures line on the balance sheet.

Disadvantages to Manual Software Capitalization

Ifrs Software Capitalization Rules

The current manual approach is a necessity for many businesses, but it opens up unnecessary opportunities for error, waste, and frustration for accountants and managers. Here are some of the pitfalls of capitalizing software expenditures manually.

1. Manually capitalizing is tedious and time-consuming

Entering information into a spreadsheet is monotonous and eats up company time. In some cases, managers have to spend valuable time just finding the correct information before they can begin entering the data.

2. Manually capitalizing is inaccurate

When entering a lot of data into a spreadsheet, there will invariably be errors. Managers roughly estimate the time employees spent on projects. Sometimes they simply forget which employees worked on which projects and for how long.

Additionally, typos are common and it’s easy to enter information in the wrong field. When you put these factors together, you end up with inaccurate results.

3. Manually capitalizing means missed projects

Sometimes engineers do not communicate to accounting that they started new projects. In some cases, significant time passes before the accounting team is aware of a capitalizable project.

In short, capitalizing software manually is difficult and unreliable. Fortunately, there will be another option in the future.

How software capitalization will be done in the future

In the future, with GitBloom, accountants will be able to capitalize software programmatically. This solves many of the common problems that companies face when capitalizing software costs.

Capitalization Of Purchased Software

With GitBloom CapEx software, accountants will be able to manage the software capitalization process automatically. Here are just a few of the powerful features that accountants will have access to with GitBloom.

1. Detect new projects in the preliminary stage

Engineering managers and product managers often start new projects without communicating with the accounting department. Now, whenever software developers create a new microservice, file, or module, Gitbloom will automatically notify accountants.

This can spur accountants to chat with engineering managers and product managers to determine whether or not the new project is eligible for capitalization. Accountants receive these notifications in real-time, ensuring that accounting departments never miss a new capitalizable project again.

2. Detect when a project is in the development stage

GitBloom plugs into your company’s signals, metrics, or logging systems and detects when engineers start developing the software. This means accounting immediately knows when workers begin developing a project and who in the engineering department is in charge.

3. Measure where engineers spend their time

Accountants can determine which engineer has worked on which project by inspecting lines of code. GitBloom records pull requests, commits, and pushes for every service, file, and module. All of this can be done in real-time.

This allows accountants to measure how long each engineer has spent on each project. Then, accounting can discuss measurements with an engineering manager or product manager to determine where to allocate engineering time.

4. Calculate the software value

GitBloom pulls measurement data from your company’s Git repository. This includes:

Assembla
AWS
Azure DevOps (TFS)
Beanstalk
Bitbucket
GitHub and GitHub Enterprise
GitLab
Google Cloud, and more

GitBloom can also pull salary data from your company’s payroll system, including programs like Workday, Gusto, BambooHR, and more

By combining the repository and payroll data, GitBloom can estimate the value of capitalization. Accounting teams can then make adjustments based on other input to arrive at the final value of software capitalization in a given period.

Accountants can then pull and share a report of all this information with auditors to corroborate how they arrived at the capitalization value.

Automation is the future of software capitalization