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Do Software Development Costs Need To Be Capitalized?

The first ‘S’ in SaaS means software. Software costs money to develop. The question is, Do software development costs need to be capitalized?

GAAP has rules for capitalization of software development costs. The rules depend on whether the developed software will be used internally or sold externally.

The Short Answer is Yes

GAAP states that certain costs for both internal-use and external-use software should be capitalized. We won’t dive into the complicated specifics in this article. For now it’s enough to know that software development generally involves capitalization under GAAP. 

Accounting Standards Codification (ASC) 350-40 and 985 state the capitalization rules for internal-use and external-use software, respectively.

Practice vs Theory

GAAP rules are one thing. In practice, many companies expense development costs as they are incurred. 

The SaaS model does not fit easily into legacy GAAP software rules. The rules were written years ago for the software licensing model, not the subscription model. (How long has it been since you purchased a hard copy of any software and uploaded it through a CD drive?)

Licensed software development followed a linear process. Planning and design gave way to development, testing, and then marketing. Annual releases of updates or new versions were common.

Today, monthly updates are common. In addition, development is continuous. The agile development model builds different modules at different times and speeds. A phase can begin before another one ends. Once-obvious questions such as “When is software completed?” or “What is the useful life of this software version?” can be difficult to answer.

The Bottom Line

The bottom line is this: what accounting policy is best for your organization and your stakeholders? Perhaps everyone but your auditor finds expense-as-incurred more useful than capitalization. If you decide to expense development costs, document your rationale. That way you can have an informed discussion if anyone asks why you are not following the current accounting guidelines.

SaaS Capital and CIO have good articles on this topic. 

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