Capital vs Operating Expense: Is Software a Capital Expense?

In accounting, expenses are categorized into two main types: capital expenses and operating expenses. Capital expenses are costs that benefit the company for more than a year, while operating expenses are costs that are incurred to generate revenue in the short term.

The IRS defines capital expenses as assets that have a useful life of more than one year, such as equipment and buildings. However, software can sometimes be a gray area, as we'll explore.

For example, in the article, we discussed how the IRS considers software to be a capital expense if it has a useful life of more than one year, but an operating expense if it's used up within a year. This can be a major difference in how companies account for software costs.

Consider reading: B Capital

CapEx is incurred to purchase or improve a long-term asset, such as property, plant, and equipment (PP&E). This can include large one-time expenses that are expected to provide a benefit to the company for many years.

An example of a CapEx is the purchase of a building, which is a long-term asset that will benefit the company for years to come.

Capital expenses are typically one-time expenses, whereas operating expenses are recurring. This means that CapEx is a significant upfront cost, whereas OpEx is an ongoing expense.

Operating expenses, on the other hand, are expenses incurred in the normal course of business activities. Examples of OpEx include rent, utilities, and salaries.

These expenses are required to keep the company functioning on a day-to-day basis and are typically incurred regularly.

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Custom software can be considered an operating expense (OpEx) if it's not tailored to meet a company's specific needs. This is often the case with off-the-shelf software that requires only minor customizations.

Off-the-shelf software is a good example of OpEx, as it can be easily purchased and used without significant modifications. In fact, customizing off-the-shelf software with minor changes is more likely to be an operating expense.

Here are some key characteristics of OpEx custom software:

If your custom software falls into one of these categories, it's likely to be considered an operating expense.

Software development costs can be capitalized under specific conditions, but the rules can be subjective and challenging to apply.

To be eligible for capitalization, software development costs must meet certain criteria prescribed under GAAP, such as technological feasibility for software intended for sale or internal use.

There are two stages of software development where costs can be capitalized: the application development stage for internal-use software and the stage when technological feasibility is achieved for software to be sold or marketed to the public.

The accounting and forecasting best practices for capitalized software costs are virtually identical to that of intangible assets: the costs are capitalized and then amortized through the income statement.

Companies have different approaches to capitalizing software development costs, with some being conservative and others less so.

Google capitalizes virtually no software development costs, while companies like AthenaHealth capitalize a significant amount of development costs for internally used software.

Related reading: Prepaid Expenses Need to Be Capitalized

The FASB issued Statement No. 86 in 1985 to provide specific guidance on capitalizing software development costs for software to be sold, leased, or otherwise marketed.

The FASB's software capitalization rules have evolved over time, with the issuance of ASC 350-40 in 2018, which allows for the capitalization of certain implementation costs for cloud computing or hosting arrangements.

Here's a summary of the capitalization rules under FASB:

These rules can be complex and challenging to apply, especially in agile development environments where software development costs can change rapidly.

Capitalized software costs are costs such as programmer compensation, software testing, and other direct and indirect overhead costs that are capitalized on a company's balance sheet instead of being expensed as incurred. This means that these costs are recorded as an asset on the balance sheet and then amortized over time.

Companies can capitalize software development costs if the software being developed meets certain criteria, such as being for internal use or having achieved technological feasibility. According to GAAP, costs incurred during the application development phase can be capitalized if it is probable that the development will result in new or additional functionality.

Take a look at this: Accruals Balance Sheet

The decision to capitalize software development costs is subjective and can vary between companies. For example, Google capitalizes virtually no software development costs, while companies like AthenaHealth capitalize a significant amount of development costs for internally used software.

To be eligible for capitalization, software development costs must meet specific criteria, such as being for internal use or having achieved technological feasibility. According to GAAP, costs incurred during the application development phase can be capitalized if it is probable that the development will result in new or additional functionality.

Here are the two stages of software development in which a company can capitalize software development costs:

1. The application development (i.e. coding) stage for software intended for a company's internal use.

2. The stage when “technological feasibility” is achieved for software that will be sold or marketed to the public.

The accounting and forecasting best practices for capitalized software costs are virtually identical to that of intangible assets: The costs are capitalized and then amortized through the income statement.

Capitalized software costs can have a significant impact on a company's financial statements, including lower reported expenses and higher net income. However, the decision to capitalize software development costs does not necessarily mean that it will be capitalized for tax purposes.

Additional reading: Define Working Capital Management

Software development costs can be categorized as either operating expenses or capital expenditures. According to the IRS, there are two tax treatments for software development: accounting for all software development costs as current, deductible expenses or accounting for software development costs as capital expenditures to be amortized over 5 years from the date of completion or 3 years from the date the software is placed into service.

Companies like AthenaHealth capitalize a significant amount of development costs for internally used software. In their 2017 10K, they explain that it is for internal use software called AthenaNet.

The accounting and forecasting best practices for capitalized software costs are virtually identical to that of intangible assets. The costs are capitalized and then amortized through the income statement.

According to FASB guidance, software capitalization rules for software purchased or developed with internal use in mind vary from the rules regarding software for sale. Implementation costs, or costs after planning and design, for internal-use software are capitalizable while the ongoing maintenance costs are not.

Broaden your view: What Accounting Account Is Finance Charge Expense

Here are the stages of software development and their corresponding treatments for internal-use software:

To capitalize software development costs, the software being developed has to meet certain criteria prescribed under GAAP. The two stages of software development in which a company can capitalize software development costs are:

1. The application development (i.e. coding) stage for software intended for a company's internal use.

2. The stage when "technological feasibility" is achieved for software that will be sold or marketed to the public.

Software development expenses are categorized by what stage of the development process they were incurred. Generally, planning and testing costs necessary to establish that the product can be produced to meet its design specifications or maintenance costs are considered operating expenses.

Tax treatment can be complex, but let's break it down. For unincorporated businesses, revenue expenditure is fully deductible at the time it's recognised, whereas capital expenditure can't be deducted but may qualify for capital allowances.

If you're an unincorporated business, you're in luck if your computer software qualifies for capital allowances under s71 CAA 2001. This means you can deduct the cost of the software over time, rather than all at once.

Companies have it a bit tougher, with specific rules for intangible assets in the corporation tax regime. There are three possible scenarios depending on whether the expenditure is revenue or capital, and how it's accounted for in the accounts.

If the expenditure is revenue in nature, it's generally deductible in full at the time it's recognised. However, if it's capital in nature and accounted for as a tangible asset, capital allowances may be available if the asset functions as plant or is software.

Here are the possible tax treatment scenarios for companies:

If the intangible assets regime applies, the tax relief will follow the accounting treatment, with amortisation or impairment deductible for tax purposes as and when recognised in the accounts. However, there are some exceptions, such as if the intangible asset was created or acquired before 1 April 2002, or if it was acquired from a connected party.

Explore further: What Expenses Can Be Deducted from Capital Gains Tax

Capitalizing software can result in lower reported expenses and higher net income, as it's capitalized and then amortized instead of being expensed.

AthenaHealth is a great example of a company that capitalizes software development costs for internally used software. They capitalize costs related to the development of their internal-use software, including employee compensation and consulting fees.

These capitalized costs are then amortized on a straight-line basis over the estimated useful life of the asset, which ranges from two to five years. This means that AthenaHealth is able to spread out the cost of developing their internal-use software over several years.

The decision to capitalize software costs for GAAP purposes does not necessarily mean that the same costs should be capitalized for tax purposes. Companies may choose to capitalize software costs for book purposes to show higher net income, but this may not be the case for tax purposes.

Capitalizing software development costs can have a significant impact on a company's financial statements. For example, AthenaHealth capitalized a significant amount of development costs for their internal-use software, which resulted in a substantial increase in their capitalized software assets.

Customization and development play a significant role in determining whether software is a capital expense. The level of customization required for the software is an essential factor, with highly customized software being more likely to be a capital expense.

If the software is tailored to meet a company's specific needs, it may be considered a capital expense (CapEx). For instance, custom software developed to automate a manufacturing process and tailored to the company's needs is more likely to be a capital expense.

Customization can be a complex process, but it's worth noting that costs related to software development, such as software developer compensation, allocation to indirect overhead, software testing, and other direct costs, can qualify for capitalization.

Software development costs incurred after technological feasibility has been established and before market release are considered capital expenditures. This means that companies can capitalize costs related to purchases of software or software licenses, software development, coding and testing, or purchases of external materials.

However, costs related to the ongoing operation of software or software licenses, such as training, manual data conversion, or maintenance and support costs, are not capitalizable. This distinction is important for companies to keep in mind when determining whether software development costs are capital expenses or operating expenses.

Here are some key points to consider:

Custom software expenses can be a complex issue for businesses to navigate. Whether it's considered a capital expense or an operating expense ultimately depends on various factors.

Its application is one such factor, as custom software designed for long-term use may be viewed as a capital expense. On the other hand, software with a shorter useful life might be classified as an operating expense.

The cost of the software is also a consideration, as high-cost custom software might be seen as a capital expense due to its significant upfront investment. However, low-cost custom software with a minimal upfront investment might be viewed as an operating expense.

Customization is another key factor, as software that is heavily customized for a business may be considered a capital expense due to its tailored nature. The impact on business operations is also crucial, as custom software that significantly improves operational efficiency may be viewed as a capital expense due to its long-term benefits.

Accurate expense tracking is essential for businesses to make informed decisions about their investments in custom software. This involves carefully considering the various factors that influence the classification of custom software expenses.