If you’re looking to reduce your company’s tax liability, you might want to save on software costs – so what is capitalized software?
Capitalized software refers to the capitalization of a number of costs related to software installation and maintenance, including programmer fees, software testing, and other overheads that are capitalized on a company’s balance sheet at the end of the tax year.
Read on to find out what you need to know about capitalized software and whether it can be a feature of your annual tax return.
What Does it Mean to Capitalize?
The process of capitalizing is when you record a cost or expense on your company’s balance sheet to delay full recognition of the expense. The process enables companies to acquire new assets (such as software) with long-term lifespans, enabling them to amortize the cost.
Understanding how to capitalize can save your business money in terms of tax liability. It can also help the balance sheet look good by improving the net profit and reducing the expenses listed.
This is one of the main reasons why many business owners look to capitalize on costs wherever possible.
As we explain in this article, many firms take the option to capitalize software, so we explain everything you need to know, how it works, and what you need to think about before getting started with the process.
When Can a Company Capitalize on Software Costs?
If you plan on capitalizing on software development costs, you must first check that the software is eligible, as outlined by Generally Accepted Accounting Principles (GAAP guidelines).
That being said, there are two stages of software development in which a company can capitalize:
- The coding stage for internal software.
- The stage where ‘technological feasibility’ is achieved for software to be released to the general public.
While there are several things you need to consider before opting to capitalize software within your company’s reports, it’s something that you can run past your accountant for advice if you’re not sure if you meet the parameters.
Ultimately, software capitalization is the process of regarding software as a type of fixed asset.
Expensing assets enables a business to reduce its taxable income and liability, which can lead to increased potential investment.
Which Costs Can Be Capitalized?
As mentioned, the GAAP has specific guidelines relating to the capitalization of software, and the two stages introduced above are helpful parameters, to begin with.
Most companies begin the capitalization process after the initial stages of software development when the project’s funding is assured.
Specifically, you can capitalize the following:
- Compensation of programmers, software developers, and other employees who contribute to software development.
- Consulting fees are used to pay third-party developers working on software-specific projects.
- Costs related to testing software.
- Direct and indirect overheads.
The business leaders and accountants are responsible for putting together a list of costs for software capitalization, and they must be relevant to early-stage internal software or the technological feasibility stage for any external software projects.
What are the Benefits of Capitalizing Software?
The key thing to realize about capitalized software is that it is amortized rather than expensed. Therefore, it reduces the reported expenses of your business and results in higher net income. This process helps to paint a much healthier financial picture for your business.
Therefore, capitalizing software is a viable option if your company is looking to show as high a net profit as possible.
Specifically, software capitalization can benefit software development, finance, and project management companies.
Capitalization can make a company’s books seem more profitable by reducing expenses.
This is particularly helpful if you’re seeking to attract outside investment for your company to achieve further growth.
How Long is Software Capitalized?
As a result of new legislation passed in 2022, domestic software development costs must now be capitalized over five years. The time extends to fifteen years if the capitalized costs are associated with a foreign project.
Previously, there were options to capitalize over three or five years, but this is no longer the case.
It’s also important to acknowledge that the amortization must still run its course once the software is retired or no longer required.
Company executives and their accountants are responsible for understanding the financial implications of capitalizing software and must ensure that they meet the parameters for doing so, as already introduced in this article.
If eligible, your company can capitalize on software costs to reduce your expenses and increase your net profit, which is particularly beneficial if you’re seeking external investment for your firm.
So, for some companies, capitalized software can be beneficial. However, it’s important to note that software capitalization isn’t appropriate for every company, so you should consult your accountant before making a decision.