If you are familiar with generally accepted accounting principles, commonly referred to as GAAP, you are aware that fixed assets are normally capitalized and appear on the balance sheet. Capitalizing an asset allows you to recognize the expense of the asset over a longer period, typically the useful life of the asset. This is in keeping with the GAAP concept of matching revenue and expenses to the correct period.
To illustrate, suppose you pay $50,000 in June to purchase a delivery truck for your company. Your revenue for June was $40,000. If you were to record the entire purchase amount as an expense, your income statement would reflect a loss of $10,000 for the month. Since the truck has an expected useful life of five years, however, this means that your profits would be overstated for the next 59 months. Instead, you should recognize a portion of the $50,000 every month for the five years of the truck's useful life.
What many people do not realize is that software can be capitalized just like any other fixed asset. However, there are certain rules that apply specifically to software.
The software must be developed or acquired strictly to serve the company's internal needs. In other words, software that you plan to market outside of your own company generally does not qualify as a capital asset. Thus, if you have a new custom business productivity software developed for your company's internal use, it would qualify, but if you have a same product developed with the intent to sell it to other businesses, it would not. Conducting a market feasibility study does not automatically imply an intent to market the software, but a history of developing software for internal use and then marketing it can lead to an assumption that the current project will also be sold to external buyers.
Common types of software that normally qualify as capital assets include accounting systems, membership tracking systems, cash management tracking systems and production automation systems. In general, the software must be developed to benefit the company's operation in some manner rather than as a product intended to generate a profit through sales of the software. This does not mean that only your employees may use the software. For example, if you develop a pricing and billing system, you could allow customers to access their invoices online or look up their price on an item that you sell.
Certain costs incurred cannot be included for capitalization; they should be recorded as an expense when they are incurred. Expense the following items:
The costs you should capitalize are those that are directly related to the development, deployment and testing of the software. Begin capitalizing costs once the preliminary tasks are completed, management has committed to fund the project and you can reasonably expect that the software will be completed and used as intended. Stop capitalizing costs once all substantial testing is complete.
You can capitalize the following costs:
Should it become apparent that the project will not be completed, you should immediately stop capitalizing costs. Typically, software that has not been completed has no value, so if you have already capitalized costs, you should consult your accounting professional for advice on expensing these costs.
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