Understanding how and when to capitalize software research and development (R&D) are questions most technology companies will have to ask at some point in their business operations.
We've answered some of the most common questions BDO leaders are asked about capitalizing software R&D.
What is the capitalization of software R&D?
Capitalizing software research and development is classifying research and development activities as an asset instead of an expense. For those working in software development, finance, or project management, it is essential to understand the accounting guidelines of capitalization of software R&D, not only for accounting accuracy but to ensure you are meeting the goals of your organization's key stakeholders. If a company chooses to capitalize all or some of its R&D costs, they will be removed as losses in the profit and loss sheet and moved instead as assets on a balance sheet. This way, the costs of developing new software would be amortized over a period.
Should I capitalize internal research and development costs?
Under IFRS, ASPE, and U.S. GAAP accounting rules, research costs are always expensed. However, development costs related to software developed for external use can be capitalized if certain criteria are met, most importantly the establishment of technical feasibility. The specific rules vary between IFRS, ASPE and US GAAP. Under IFRS and U.S. GAAP if you meet specific criteria then you must capitalize development costs. If you use ASPE, even if you meet the criteria you can still choose if you want to capitalize software R&D or not.
What is industry practice?
In Canada, many of the top technology companies (as measured by market cap) do not capitalize development costs related to software to be sold. The typical disclosure on the topic is as follows, “Costs incurred between the dates that the product is technologically feasible and is considered to be ready for general release to customers …have not been significant.”
Capitalization of development costs is more common among smaller, public Canadian technology companies.
You should also look at how your investors and key stakeholders evaluate the success of your company and how this policy can impact key performance indicators (KPIs).
Will I receive any benefit from a buyer if I capitalize development costs?
Ryan Farkas is Managing Director, M&A and Capital Markets at BDO and has worked on the sale of numerous technology companies. In his view, “Capitalized software costs and the related amortization are a common add back that are looked at quite closely by buyers when evaluating a target. Buyers are concerned with the results of research and development efforts and the cash flow impact, not the accounting. Capitalizing the development costs aren't critical.”
Choosing a policy that best reflects your business and investors' needs is essential.