Amortized Software Development Costs Explained Clearly

Amortized software development costs are a crucial aspect for companies that develop software, especially in today’s fast-paced, technology-driven business world.

The costs could be significant in developing the software, and by amortizing those costs, companies can better budget and tax report as well as remain compliant with accounting guidelines. 

In this article, we take a deeper look into what amortizing software development costs means and the ways companies can go about it, along with some of the best practices to follow when making financial decisions.

What Are Amortized Software Development Costs?

Amortized software development costs refer to the expenses incurred during the creation of software that are capitalized and then gradually expensed over the software’s useful life. 

Rather than incurring a large financial burden by recording all costs upfront, businesses spread out the payments over several years. This process provides a more manageable way of dealing with large development costs and helps businesses align expenses with revenue generation.

For instance, a software development company might incur substantial costs in building software, but by amortizing the total development cost over 5 to 7 years, companies—whether working in-house or with an offshore software development company—can avoid significant financial strain while aligning expenses with revenue generation.

This also provides a clear understanding of the software’s value over time, making it easier for businesses to gauge the financial impact.

When to Amortize Software Development Costs

As a software developer or business owner, you need to be aware of when to start amortizing software development costs. 

The primary determinant under accounting requirements is whether the software is ready for use. Amortization does not kick in until after the software has come to its development stage and is ready for its intended business use.

Capitalizable Costs vs. Non-Capitalizable Costs

Not every expense associated with software development may be amortized. The costs that can be capitalized are limited:

• Capitalizable Costs: These are the costs associated with developing the software, including coding and testing, during the development process. Such costs have a direct relationship to rendering the software operational and, accordingly, are capitalized and amortized (common in offshore software development projects).
• Non-Capitalizable Costs: These could be all the stages of software development, for example, research, idea, and planning. Because these costs are expended prior to the software being capable of being used, they are not capitalized.

For most companies, capitalization can commence once the development of software commences with coding or testing. Amortisation commences from the date when the software is available for use and revenue can be earned through such use.

Methods of Amortizing Software Development Costs

Many different techniques may be employed in amortizing software development costs, and the appropriate method can vary depending on the software and the business model.

Straight-Line Method

The simplest among them is the straight-line method. With this method, the entire development expense is spread out throughout the course of the program. This assumes that the software will provide consistent value throughout the period.

Let’s say a business, unsure how much does it cost to develop software for enterprise needs, invests $100,000 in an application. Using this method, they would amortize $20,000 annually over 5 years.

• Pros: Simple to apply and understand, it would offer a predictable expense each year.
• Cons: May not accurately represent the software’s real value over time, and would especially fail to do so if its value were to decrease rapidly.

Accelerated Amortization

The accelerated amortization also means larger amortization costs in the first few years of the software’s life. This becomes especially advantageous if the software is expected to depreciate at a faster rate or offers higher benefits during its earlier periods.

A company might, for example, calculate that its software will lose 40% of its value in year one, and 20% in years two, three, and four. In such a scenario, amortization for the software would record the greater loss in the initial years and smaller losses in the final years.

• Pros: Provides tax savings up front, and costs match the usage of the software.
• Cons: The tax credits are front-loaded, so they do not always mirror the software’s performance.

Ratio-of-Revenues Method

The ratio-of-revenues method amortizes software development costs based on the revenue the software generates during each period. This approach aligns the amortization expense with the actual economic benefit the software provides.

• Pros: Provides a more accurate reflection of software value and revenue generation.
• Cons: Complex to implement and requires detailed revenue data.
  

Factors Affecting the Amortization Period

The timeframe over which software development costs are amortised depends on various factors. It is dominated by the following critical issues:

• Type of Software: Custom software tends to have a longer amortization period (usually 3-5 years) compared to off-the-shelf software, which often has a shorter life span due to frequent updates and new versions.
• Technology Developments: The speed at which technology is developing could shorten software’s lifespan. If a technology product is displaced by new technology prematurely, the amortization period also may need to be revised.
• Software Upgrade and Improvement: If a business periodically upgrades or improves its software, the useful life can be extended, which impacts the amortization period.
• Maintenance costs: Maintenance is not capitalized in most cases, but if the software is significantly updated or regularly replaced, then the amortization period can be prolonged

Amortization in Each Phase of Software Development

In order to make an accurate assessment of software development costs, it’s also important to know the various stages that go into the software development life cycle. For each phase of the project, there are different types of costs, of which some can be capitalized. This understanding also provides a clearer picture of how to develop a software efficiently, from planning to deployment.

Planning

The first phase is project planning, when the goals and scope are carefully established. This stage usually consists of preliminary investigation and conceptualization, and costs are not capitalized.

Analysis

During requirements analysis, the business looks at the technical and feature requirements of the program. The cost can generally be capitalized in this scenario, since such costs pertain to the future use of the software.

Design

The design phase is where you define the technical specs and detailed plans for designing the software. Such costs may also be capitalized.

Implementation

During the implementation phase, actual programming takes place. This is the most critical phase for capitalizing costs, as it directly impacts the functionality of the software.

Testing

Testing is a critical stage of any software development process, which helps to detect and fix defects. The cost of testing may be capitalized if the software is ready for use.

Deployment

Deployment is the stage when the software becomes live or is accessible for use. Deployment-related expenses are typically recorded as incurred.

Maintenance

Maintenance consists of modifications to the software that take place post-deployment. These expenditure is normally written off as incurred, although there may be a possibility of capitalizing significant improvements.

Accounting Standards: GAAP vs. IFRS

Businesses must follow certain accounting rules when deducting software development expenses, mainly IFRS (International Financial Reporting Standards) and GAAP (Generally Accepted Accounting Principles). Depending on the software’s location and intended use, these standards offer recommendations for how expenses should be handled and capitalized.

• GAAP: From a GAAP perspective, software development costs can be capitalized under certain conditions. This usually consists of costs in the development phase and when the software is for use internally, rather than for sale. But GAAP also dictates that only certain costs, coding, testing, and software design, can be capitalized, and companies must show that those costs can be directly linked to functionality in the software.
• IFRS: It allows more liberties in capitalization of software costs for software made for sale in the marketplace. It also lets firms interpret more widely what can be capitalized, such as some research and development costs. IFRS emphasizes the future economic benefits that the software will deliver, and the capitalized costs for software developed for external customers are made simpler.

The goal of both standards is to bring financial transparency, but those rules look different, so businesses should understand what rules apply to their unique circumstances.

Types of Costs Eligible for Capitalization

Software development expenses must have a direct connection to the software’s creation in order to qualify for capitalization. Eligible costs include:

• Development Costs: Costs associated with programming, designing, and testing required to make software operational.
• External Costs: Contracting third-party developers to perform work that is tied to software development initiatives.
• Testing and Debugging: The costs of testing the software, repairing defects, and verifying its functionality are capitalized.
• Software Licences: Costs of acquiring third-party software licences necessary for the development can be capitalised if used for more than a year.
• Initial Data Migration: Costs incurred to bring data into the new application structure are capitalized to the extent of enabling the software to function.
• Project Management and Direct Labor Costs: Direct labor for team members who are working directly on development is capitalized.

Special Considerations

Amortization for certain software, particularly cloud-based software, poses unique challenges. Cloud-based software, unlike most traditional software, typically works off a subscription-based revenue model, collecting revenue over time in return for access, rather than through a one-time licensing fee. 

It makes it challenging to compare revenue recognition with amortization. In addition, cloud-based software tends to be updated and modified at a rapid pace, and the life cycle of such modifications may last and increase the life of the software and its useful period. 

Businesses must also update their amortization schedules frequently to accurately reflect the changing value of the software. Careful attention to these requirements will help to avoid violations of accounting standards and will facilitate the preparation of accurate financial statements.

Best Practices for Managing Amortized Software Development Costs

In order to maintain the necessary level of transparency and accountability in reporting costs of software development, businesses need to follow the best practices in holding amortizable software development costs:

• Track Costs in each phase: Maintain records of the costs by each phase of development.
• Review Periodically: Periodically evaluate the useful life of the software and make necessary changes to amortization schedules.
• Consult with Accountants: Collaborate with accountants to make certain that all relevant guidelines and regulations are met.
• Develop a Cost Tracking System: Utilize software or tools to monitor cost and catch any discrepancies early.
• Keep Clear Documentation: Record all decisions, key deliverables, and amortization adjustments.
• Align Amortization with Revenue Recognition: Match Amortization with Revenue to improve financial performance transparency.

Conclusion

Amortized software development costs are an important financial consideration for the software development company. 

Businesses may more precisely match their expenditures with income generation by capitalizing costs and spreading them out across the software’s useful life.

Understanding the right time to begin amortizing, choosing the proper method, and following accounting standards are crucial for ensuring financial clarity. 

Strategically mapping out best practices for adoption, organizations can benefit from a more optimized financial strategy, streamlined tax reporting, and an overall competitive advantage in the long run.