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Accounting for Software Development Costs

Many companies develop software internally to sell to others. But which costs are research and development expenses and which costs can be capitalized and then amortized? Technological feasibility is what separates these two costs and once determined, dictates the accounting treatment.

What is technological feasibility and when does it occur? This occurs when the program model or working model of the software is complete. You’ve done your research, designing, coding, and testing of the software product, and now you’ve decided to continue with this product and prepare for the transition to production. It might not be ready to market; however, the commitment is made to continue with the product.

The costs you might incur when internally developing software are summarized below in chronological order:

  • Software Development – Costs are expensed as research and development expenses.
  • Costs AFTER establishing technological feasibility – Additional costs of coding, testing, debugging, and reparation of final product master and final documentation manual. These costs are capitalized as an intangible asset and amortized.
  • Software production costs including duplication of product masters and manuals – Capitalize in inventory and expense through cost of goods sold as sales take place.
  • Customer support and maintenance – Expensed as incurred.

Once you’ve got your cost classifications figured out, the capitalized intangible asset must be amortized every year. This is determined by taking the larger result of the revenue method or the straight-line method. This calculation for both methods must be done every year with the larger amount always recognized.

  • Revenue Method = Book value of capitalized software costs X (current year revenue/estimated future revenue plus current year revenue)
  • Straight-Line Method = Book value of capitalized software costs/number of years remaining in product sales life

If this affects you, be sure to read the full guidance per FASB Accounting Standards Codification Topic 985-20, or reach out to your CPA.

By Audrey D. Richards