Software Capitalization Rules under US GAAP and GASB

The waterfall approach was commonly used to manage software development projects in the past. More specifically, specified research expenses must be treated as Section https://www.bookstime.com/blog/hoa-accounting 174 capitalized costs in order to be considered QREs under Section 41. Therefore, taxpayers must insure QREs are included in their overall Section 174 computation.

Although these guidelines seem straightforward enough, the timing of a shift from on-premises to cloud delivery may not always be clear. In a waterfall world it was easier to align development cost to these sequential phases. It was also normal to do more up-front design and analysis work to establish technical feasibility, again as its own distinct phase. But now we live in an agile world, where almost all companies strive to release new feature functionality frequently, some every second or minute – and some every quarter or annually depending on their capabilities and their type of product and customer.

What is the definition of technological feasibility when a company is internally developing software?

Therefore, if the CFC has been expensing R&E costs, these costs would now need to be capitalized over a life of 15 years in the GILTI-tested income calculation. When software is purchased by an entity and used directly out of the box, under US GAAP it is recorded on the balance sheet as an intangible asset at purchase price and amortized over its economic or legal life, whichever is shorter. The economic life is the period over which the intangible asset contributes to the cash flows of an organization. If the asset has an indefinite useful life, it is not amortized, but must be analyzed periodically for impairment of value.

• Instead, a company needs to develop processes and controls that allow it to make that distinction based on the nature of different activities.
• If the only NOLs for the corporation were created after December 31, 2017, the company utilization of the net operating losses will be limited to 80% of taxable income.
• While taxpayers will still receive a benefit for the R&E costs that are paid or incurred, these costs can no longer be deducted in the current tax year.
• Now that we see the financial position difference, let’s consider the pros and cons of capitalizing R&D expenditures in order to develop a philosophy and point of view for our own products.
• By amortizing the cost over five years, the net income of the business is smoothed out and expenses are more closely matched to revenues.
• Careful planning can aid in the analysis of which costs to capitalize versus expense.

Accordingly, how Sec. 174 costs are defined also has implications for the research credit under Sec. 41. © 2023 KPMG LLP, a Delaware limited liability partnership and a member firm of the KPMG global organization of independent member firms affiliated with KPMG International Limited, a private English company limited by guarantee. Expect future articles addressing the definition of a business under finalized amendments to IFRS and any differences from US GAAP, and the accounting for IPR&D.

IFRS Perspectives: Update on IFRS issues in the US

Taxpayers should consider developing a process for identifying and tracking Section 174 expenditures in addition to implementing appropriate internal controls. Depending on a taxpayer’s facts, it may be reasonable to begin with either expenditures under Section 41 or ASC 730 and make the necessary adjustments to arrive at Section 174. “Development” is the translation of research findings or other knowledge into a plan or design for a new product or process or for a significant improvement to an existing product or process whether intended for sale or use. It includes the conceptual formulation, design, and testing of product alternatives, construction of prototypes, and operation of pilot plants. In addition to the examples in the regulations, interpretive guidance has been issued over the years that provides some insight regarding what costs are subject to Section 174 treatment.

Also similar to FASB, the definition of this stage is less broad than the capitalizable costs for internally developed software under US GAAP. Installation, testing, and parallel processing are deemed to be application development activities, but training is defined as a post-implementation activity. The history of software capitalization for state and local governments is similar to that of FASB. Issued June 2007, GASB 51, Accounting and Financial Reporting for Intangible Assets provides a summary for rules regarding software capitalization to provide consistency for how organizations should account for the intangible assets.

Accounting for software development cost in the age of cloud and agile

The current lack of guidance from the IRS and Treasury poses a challenge to taxpayers, who must make reasonable interpretations when modeling the impact of the new rules under Sec. 174 for purposes of financial statements and estimated tax payments. In a typical cost-sharing arrangement, the CFC reimbursement would reduce the R&E expenditures reported by the U.S. parent such that the U.S. parent would report its income and expenses on a net basis. It also is important to maintain additional internal controls such as monthly reviews of activities, capitalized and expensed amounts, and communication templates that project managers can fill out to verify that employee time is coded correctly. The methods technology companies use to develop new software for their customers have changed in recent years, making applying the rules for capitalization of software development cost more challenging.

However, in the case of an M&A transaction, the R&D expenses of the target company may sometimes be capitalized as part of goodwill, because the acquirer can recognize the fair value of the R&D assets. The R&D costs are included in the company’s operating expenses and are usually reflected in its income statement. When software is developed for sale, or external use, the accounting treatment differs slightly. The capitalizable and non-capitalizable costs are still delineated by where or when in the process they occur, but the guidance becomes more granular.

R&E expenditures that were neither treated as current expenses nor deferred and amortized were required to be charged to a capital account and possibly amortized under Sec. 167. Alternatively, taxpayers that used a current expense method under Sec. 174 could elect annually under Sec. 59(e) to recover their R&E expenditures over a 10-year period. Many companies employ an agile model accounting for r&d for developing software to be sold, licensed, or otherwise marketed (known as external-use software), simultaneously carrying out activities such as development and testing on different components of the software. GAAP outline capitalization requirements based on the waterfall approach (see the “Waterfall Approach” chart), in which activities happen in a specific sequential order.