The 3 Stages of Capitalizing Internally Developed Software

Introduction to Capitalization of Internal-Use Software Costs

Capitalizing Internal-Use Software Costs under GAAP (Codification Topic 350-40)

Capitalization of costs related to internal-use software is a practice often misunderstood by companies when adhering to Generally Accepted Accounting Principles (GAAP). Internal-use software typically encompasses systems meant for back-office operations, like general ledger or billing modules, and platforms that deliver software as a service to customers. It’s important to note that this accounting treatment does not apply to software intended for sale or distribution to external customers. This article will delve into the intricacies of capitalizing internal-use software costs, breaking down the process into three distinct stages, and explaining when capitalization is required.

Preliminary Project Stage

1. Understanding the Preliminary Project Stage

The initial phase of internal-use software development is the Preliminary Project Stage. During this stage, certain costs are immediately expensed as they are incurred. These costs encompass activities like exploratory research, defining the desired functionality of the software, and assessing the feasibility of existing technology to meet performance objectives, among other tasks.

Application Development Stage

2. Navigating the Application Development Stage

The Application Development Stage is where companies must capitalize both internal and external costs incurred. This phase involves critical activities such as designing the development path, coding, hardware installation, and rigorous testing. Several types of costs are eligible for capitalization during this stage, including:

• External costs related to materials and services obtained for developing or acquiring internal-use computer software, such as fees paid to third-party developers.
• Payroll and payroll-related expenses for employees directly involved in the internal-use computer software project. These expenses are restricted to the actual time spent on software development tasks, such as coding and testing.

Note: Training costs incurred during this stage should be treated as expenses and not capitalized.

To initiate capitalization during this stage, management must first authorize and commit to funding the project. Additionally, the company should have completed the preliminary project stage, and project completion should be reasonably expected.

Post-Implementation/Operation Stage

3. Understanding the Post-Implementation/Operation Stage

The Post-Implementation/Operation Stage is the final phase in the development of internal-use software. During this stage, costs should be expensed as they are incurred. This stage occurs when the software has been deployed and is actively used for its intended purpose. Costs that should be treated as expenses during this stage may include training and maintenance expenses.

Conclusion and Best Practices

4. Best Practices for Capitalizing Internal-Use Software Costs

To summarize, the correct capitalization of internal-use software costs is essential for accurate financial reporting. It involves three distinct stages: Preliminary Project Stage, Application Development Stage, and Post-Implementation/Operation Stage. Here are some best practices to ensure compliance with GAAP and make informed financial decisions:

• Thorough Documentation: Maintain meticulous records of all costs incurred during each stage of software development. This documentation will be crucial for audits and financial reporting.
• Clear Cost Allocation: Distinguish between costs that should be capitalized and those that should be expensed. External costs for materials and services, as well as payroll expenses directly associated with development tasks, should be capitalized during the Application Development Stage.
• Timely Expense Recognition: Ensure that costs are recognized as expenses during the Post-Implementation/Operation Stage, especially for ongoing expenses like training and maintenance.
• Management Authorization: Before capitalization begins in the Application Development Stage, obtain clear authorization and commitment from management. This ensures that the project is aligned with the company’s strategic goals.
• Project Milestones: Monitor project progress and assess whether project completion is reasonably expected. This is a key factor in determining when to begin capitalization.

Adhering to these best practices will not only help companies comply with accounting standards but also provide a clear picture of the true cost of internal-use software development, aiding in effective financial planning and decision-making.