Capitalizing software development costs: Rules and benefits

Accounting practices for SaaS companies are notoriously complex. When capitalizing software development costs, you must meet specific criteria, understand which costs to capitalize vs. expense, and when to do either. 

In most cases, SaaS startups develop software for clients but retain the rights to that software through a company-hosted cloud provider.  

If you are hosting the software,  you can use the Accounting Standards Codification 350-40 (ASC 350-40). Under this accounting standard, you can apply the internal-use software capitalization rule as you are not transferring the software license but rather granting a right to use the software. 

However, if your company plans to develop, sell or license the rights to the software to a customer, you will need to follow the external-use software guidelines in ASC 985-20 instead. This accounting treatment addresses the sale or lease of the software in the customer’s environment. 

For this article, we have assumed your company will retain the rights to your software in your company or company’s hosted environment and that ASC 350-40 applies. 

Using these guidelines, the following sections break down the what, when, and why questions you may have about capitalizing development costs.

SaaS startup guide to capitalizing software development costs

What is software capitalization?

Software capitalization is when a company recognizes computer software development costs  as a software asset as opposed to research and development (R&D) expenses. 

To be for internal use, you must have acquired or internally developed software only for the internal needs of your business. These software costs are then capitalized on a company's balance sheet instead of being expensed as incurred.

Why should startups capitalize SaaS software development costs? 

Though capitalized software development costs adds a layer of complexity to accounting, it helps delay the full impact of some development costs that would otherwise need to be immediately expensed. 

Capitalizing the development costs of a SaaS platform will help to better match the timing of the deduction with the use of the asset through an amortization expense. 

Capturing development costs in the early stages of a start-up’s life will reduce operating expenses in the development phase, thereby accelerating the path to a profitable net income. 

Expenses associated with the development of a SaaS platform can be deferred until the software application is in production. The capitalized software costs must be amortized when the application is in production. 

However, the period when the capitalized asset amortized will better match the period of revenue growth, enabling the company to become or remain profitable as revenue grows. 

When can a business capitalize SaaS development costs?

Generally Accepted Accounting Principles (GAAP) offer a few guidelines for when SaaS companies can capitalize costs.

If a software project is still in the preliminary project stage, it’s too early to capitalize your development cost. 

The initial phase includes steps such as outlining performance requirements for the project and gathering research on how to build software. According to GAAP, a business can begin to capitalize costs only after completing this stage. 

It is appropriate to capitalize costs when the project receives funding and is likely to be completed. The project must also be a distinct project that provides additional functionality rather than a minor modification to an existing application. 

What is required for capitalizing SaaS development costs? 

You must accomplish two key milestones before you can capitalize software development costs. These milestones reflect the criteria mentioned in the previous section.

First, you must have completed the preliminary planning stages. 

Second, management must commit funding to the project's development until it can be placed into production. 

After meeting these criteria, the next active application development stage begins, including the actual coding and testing processes. At this point, GAAP requires capitalizing eligible development costs of the internal-use software investment. 

Which SaaS development costs qualify for capitalization?

Once you determine that you have met the requirements of ASC 350-40, you must capitalize or expense costs associated with the three stages of software development. 

In the preliminary stage, you have costs associated with planning and research. Any software development cost you incur before moving into active development falls under this initial stage and therefore is ineligible for capitalization. 

Instead, you would expense these as R&D costs in the period they were incurred. 

Following the preliminary phase, after funding by management occurs, the project enters active development. At this point, you can capitalize any software cost directly related to development, like:

• Interface design
• Coding
• Configuration
• Installation
• Testing

The final, post-implementation stage occurs after software development. You may incur maintenance, bug-fixing, or training costs, but these are once again ineligible for capitalization. 

What are the primary challenges to tracking development costs? 

The primary challenge to tracking software development costs for capitalization is tracking development time related to specific projects and phases. Most startups don’t have an adequate process in place for allocating time to each stage of development.

Additionally, most software R&D teams do not have a method of accurately tracking time and recording the costs associated with the agile development of specific projects. Accurately tracking time requires a time tracking application and management review process. 

Often project costs have not been tracked at the initial stages of a project, so management may need to estimate the time and costs associated with each stage. 

Auditors may question the method used to allocate costs and require additional documentation to support allocations to the development phase and qualified projects. 

Changes to allocation methods, tracking applications and project assumptions can thus lead to accounting adjustments and restatement of each financial statement. 

And finally, the cost of tracking development stages and projects may outweigh the future economic benefit of deferring depreciation later periods. 

Therefore, many startups continue to deduct an immediate expense for application development costs, treating it as R&D rather than a capitalized cost deductible over the software’s useful life. This often results in delayed profitability for the company.

See Also: SaaS Accounting Basics: A Comprehensive Guide for SaaS Startup Founders

Feeling lost? Reach out to Zeni.

As a SaaS company leader, your expertise probably lies in your product field, not accounting practices. If you would rather worry about anything else besides capitalizing versus expensing your development costs, it’s okay. 

Zeni understands how confusing the world of business finance can get. Our dedicated finance teams, assisted by powerful AI, provide accounting and bookkeeping services that keep your books up to date and your business compliant with accounting regulations.