Capitalizing Internal-Use Software
What is internal-use software? And are you allowed to capitalize these costs?
Internal-use software includes:
- Software that has been acquired, internally developed, or modified exclusively to meet the entity’s internal needs
- During the development or modification, no substantive plan exists or is being developed to market the software externally
Incurred internal-use software costs are divided into the research phase and the development phase. All research phase costs should be expensed. The following development phase costs should be capitalized:
- External direct costs of material and services consumed in developing or obtaining internal-use software
- Payroll and related costs for employees who devote time to and are directly associated with the project
- Interest costs incurred while developing internal-use software
- Costs of enhancements or upgrades of the system
Expenses that should NOT be capitalized:
- General, administration, and overhead costs
- Inefficiencies or operating losses incurred during software implementation
- Training costs Costs of systems maintenance, updates, and minor modifications
- Fees paid to outsiders for general systems consulting and overall control reviews
For GAAP purposes, amortization should be recorded over the software’s estimated useful life when the computer software is ready for its intended use, regardless of whether the software will be placed in service in planned stages that may extend beyond a reporting period. Because technology can be quickly outdated, a shorter life would be expected (3 to 10 years).
For tax purposes, internally developed software may be deducted in three ways:
- Consistently treated as current expenses and deducted in full
- Consistently treated as capital expenses and amortized over 60 months from the date of completion of the software development
- Consistently treated as capital expenses and amortized over 36 months from the date the software is placed in service
For a company that utilizes an off-the-shelf software package for their general ledger, the cost of the software would be capitalized along with the costs of any future upgrades. Any significant payroll costs incurred to implement this software could also be capitalized.
For a company that has taken on the task of developing their own software, all costs of materials or services, payroll incurred to create/implement, and interest costs associated with implied debt servicing would be capitalized as software in progress. Once the software is ready to be implemented throughout the organization and placed in service, the software asset will begin to be amortized over the expected life.