How Do You Book a Capitalized Software Journal Entry?

Exploring Software Capitalization in Accounting

In the dynamic world of business, sometimes, off-the-shelf software just doesn’t cut it. When your company’s unique needs demand tailored solutions, you might find yourself in a situation where custom software development becomes necessary. However, it’s crucial to understand how to manage the financial aspects of this process. In this comprehensive guide, we’ll delve into the intricacies of software capitalization, covering everything from what costs should be capitalized to the journal entries required for proper accounting treatment.

1. Software Capitalization: What Qualifies?

Before we dive into the specifics of journal entries, let’s establish a foundation by discussing the criteria that determine whether software costs should be capitalized or expensed. Accounting standards distinguish between software developed for internal use and software intended for external users.

1.1 Internal Use Software

For software developed or acquired for internal use, the key considerations revolve around the project’s stage:

a. Project Stage: This initial stage involves researching various alternatives, evaluating vendor proposals, and selecting the most suitable option. All costs incurred during this phase are expensed.

b. Application Development Stage: At this stage, coding and testing are performed, and costs related to the asset include programmer compensation, payments to contractors, travel expenses, interest incurred for development financing, testing, overhead costs, server installation, and software purchases. These costs are capitalized.

c. Implementation Stage: After the software is live and in use, any costs associated with training and maintenance are expensed.

Subsequently, the capitalized software development costs are amortized over the estimated useful life of the software, typically two to five years, using the straight-line method. Both depreciation and amortization spread the cost of assets over their benefit-providing years.

2. Dealing with Abandoned Software

In today’s fast-paced business landscape, software projects can be abandoned prematurely. In such cases, any unamortized balance is expensed, and both the capitalized asset and the associated accumulated amortization are removed from the balance sheet. However, it’s essential to be aware that significant upgrades or enhancements may trigger a restart of the application development stage, leading to the capitalization of new costs.

3. Tax Considerations

It’s worth noting that tax rules for software development may differ from accounting standards. Nevertheless, segregating software development costs in your general ledger can be beneficial, especially given potential tax credits for software R&D.

4. External Use Software

Accounting standards also distinguish between software developed for internal and external use. When it comes to software intended for external users, similar principles apply, with costs divided into three phases:

4.1 Pre-Technological Feasibility

This phase encompasses research and development, and under U.S. GAAP, research and development costs are expensed as they are incurred, unlike IFRS, which allows capitalization.

4.2 Technological Feasibility

Here, research and development are substantially completed, but the software is not yet ready for sale. From this point until the software is available for general release, all costs are capitalized, although this can be a gray area that some companies choose to bypass.

4.3 Available for Sale

Once the software is ready for sale, all costs, including maintenance, training, minor upgrades, and customer support, are expensed. Amortization of any capitalized costs begins at this point.

5. Capitalization Journal Entries

Now that we’ve covered the principles, let’s delve into the nitty-gritty of capitalization journal entries, assuming that labor costs are the primary expenses to be capitalized.

5.1 Data Gathering

Gathering the necessary data for the journal entries is crucial. For costs from contractors, simply request invoices, distinguishing development work from bug fixes and maintenance. For employee-generated data, consider tracking hours worked on software development or requesting estimates from engineering management. Some companies leverage data engineers already use, like “story points” in Agile development, and apply weighted salary rates to the development time.

5.2 Journal Entry Details

Journal: Capitalized Software

Frequency: Each reporting period (e.g., monthly)

FloQast Folder Location: ‘Fixed Assets’

Journal Entry 1 (To capitalize software internally developed during June 2020):

Journal Entry 2 (To record June 2020 amortization of internally developed software asset):

6. Additional Considerations

As you navigate the complexities of software capitalization, keep these points in mind:

• Capitalizing software can be time-consuming but offers stability to your company’s net income by spreading salary expenses over time.
• Depending on your company’s tax status, there may be IRS R&D credits and payroll tax credits to benefit from.
• Maintain meticulous documentation to satisfy auditors and tax authorities, ensuring that your capitalization entries have ample supporting evidence.

7. Reconciliation

To effectively manage your capitalized software, consider implementing these reconciliation practices:

• Maintain a running list of additions and disposals by project.
• Calculate your net asset balance by rolling forward the additions, subtracting amortization, and accounting for decommissioned software.
• Avoid common pitfalls, such as failing to credit a contra expense account or not capitalizing assets by the specific project.

In conclusion, understanding software capitalization is vital for responsible financial management. By adhering to accounting standards and best practices, you can navigate the complexities of software development costs, potentially benefiting from tax credits and ensuring your financial statements accurately reflect the value of your software assets.