Startups 101: How to Properly Capitalize Software Development Costs

We discuss the pros and cons of capitalizing software development costs in a case study comparing side-by-side financial statements of a business that does it vs. does not.

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A lot of founders ask me if they should capitalize software development costs to the balance sheet - historically everyone did this but the thinking on this has recently changed. There are some advantages to doing it, namely that it makes your P&L look "better" in the short term (and the opposite long term), but the disadvantages generally outweigh the advantages.

The biggest consideration is whether you want the tax shield of the expense now or later.

In this video I compare the three financial statements for an identical company that capitalizes software development vs. doesn't capitalize it.

Sections:
0:27 how / why businesses accounted for software development historically vs. today
3:43 side-by-side comparison of business that capitalizes vs. doesn't
5:18 income statement impact of capitalizing software development
9:00 balance sheet and cash flow impact of capitalizing software development

By the end of this video, you’ll have a much better understanding of how software development capitalization affects businesses - I guarantee it.

If you have questions - leave a comment below and I'll try to help. Cheers!

#softwarecapitalization #startups #finance

[eric_andrews]

Questions? Let me know in the comments happy to discuss.

[georgearemu]

The treatment should be in line with accounting standards not how we feel. The standard provision is adequate from recognition to capitalisation and the amortised over a period of time (IAS 38); furthermore you can impair it inline with (IAS 36).

[rcuetojr]

Great vid, simplistic view and delivers the message.

[DISGUSTEDATIT]

Isnt it mandatory to capitalize all development costs until you reach launch stage of the software as per IAS 38 (IFRS)?

[consid]

It's interesting that you acknowledge that software development costs are an investment but also question capitalizing them. For startups it makes lots of sense to expense for tax purposes but I don't think a balance sheet and income statements with capitalization "confuse" most professionals. In fact, buyers will often run models as if development was capitalized to get an apples to apples comparison to other companies and to measure theoretical EBITDA with capitalization.

[deepanshusharma]

this is exactly what I was looking for ty

[manassemassuama]

Thanks for the playlist! I just don't understand why the lemon video?

[stanleymwangi]

You just answered a long lingering question. You also gave me excellent reasons to go this way onwards. I believe I asked you about the latter a couple of months ago, .... and boom! there you go!. Thank you.

[nzrnzrv]

Are startups/companies required by US GAAP to capitalize software and/or Software engineering salaries as opposed to expensing them? Thanks!

[asarkiro]

What is the software development expense (amount) representing, if the payroll is covering the wages of the people developing the software? What other expenses are there, hardware and software to write the code?

[shreyashi]

Hi Eric, great videos and i follow all your content ...is it possible to do a video on B2B sales and financial for a physical product or a Hardware product, thanks in advance

[nivethitharajan]

Thanks for the consistently amazing content.

[davidfuller-watts]

Great content Eric, enjoy your videos but how would this effect you if it’s a subscription revenue model and therefore the revenue gets deferred? Isn’t that the reason you capitalize?

[dandrus]

Great video Eric. I really enjoy your content - in fact your modeling approaches helped me land my current job! But ya, US tax law will require most of the internal use software development cost to be capitalized over some useful life, which as you point out, increases taxable income - IRS wants your money

[goransimonovski]

don't fully agree with this, your decision should be based upon IFRS standards; especially with IAS 38...and I agree to build your balance sheet especially if you are the technological company!
and it is not correct to take our the headcount expense from p&l, but instead you increase the same amount as income (profit zero) and move it record it to assets!