Before You Start

This guide assumes you have an expert-level understanding of Generally Accepted Accounting Principles (GAAP). It’s intended for CTOs, CFOs, and accountants at tech companies.

Overview

60 min
Estimated Time
Expert
Difficulty
Periodic
Review

What You’ll Learn

  • Identify the three phases of software development (SOP 98-1)
  • Differentiate between R&D expenses and capitalized costs
  • Track and categorize eligible labor and external costs
  • Apply the correct amortization schedule for capitalized software

1. The Capitalization Framework (SOP 98-1)

Software development for internal use follows three distinct phases for accounting purposes:

Expensed Phases

  • Preliminary Project Stage (e.g., conceptual design, evaluation, vendor selection)
  • Post-Implementation Stage (e.g., training, data conversion, maintenance)

Capitalized Phase

  • Application Development Stage (e.g., coding, installation, testing)

2. Differentiating R&D from Capitalization

Understanding where the line is drawn between an immediate expense and a capitalized asset is crucial.

Method A: Research & Development (R&D) Expense

Costs incurred in the Preliminary Project Stage are expensed as R&D.

Characteristics:
  • High uncertainty, exploration.
  • Before technological feasibility.
  • Costs for alternatives analysis.
Implications:
  • Reduces current year income.
  • No balance sheet impact.
  • Common in early-stage startups.

Method B: Capitalized Software Development

Costs incurred during the Application Development Stage, once technological feasibility is established, are capitalized.

Expert Tip: Maintaining robust project documentation is paramount. Detailed time tracking by developers and clear project phase gates are essential for auditability and compliance.

3. Step-by-Step: Capitalization Workflow

Here is the high-level workflow for correctly accounting for internal-use software development.

Here is a sample journal entry for capitalizing labor costs.

{
  "date": "2025-09-30",
  "entry_type": "Journal Entry",
  "description": "Capitalize software development labor for September",
  "debits": [
    {
      "account": "Software Development in Progress (Asset)",
      "amount": 75000.00
    }
  ],
  "credits": [
    {
      "account": "Cash/Accrued Payroll (Liability)",
      "amount": 75000.00
    }
  ]
}

4. Tracking & Accounting for Costs

  1. 1

    Define Project Phases Clearly

    Establish internal criteria for when the Preliminary, Application Development, and Post-Implementation stages begin and end. This is critical.

  2. 2

    Track Labor Costs by Phase

    Implement time-tracking systems that allow developers to log hours specifically against each development phase of a project.

  3. 3

    Categorize External Costs

    Ensure all third-party expenditures (e.g., consultants, licenses) are also allocated to the correct development phase.

Common Pitfall: Premature Capitalization

Capitalizing costs before technological feasibility is established is a common error. Ensure you have demonstrable evidence that the project is viable before beginning capitalization.

5. Amortization & Reporting

Reporting Checklist

  • Establish a reasonable amortization period (e.g., 3-5 years)
  • Record monthly amortization journal entries
  • Conduct annual impairment reviews of capitalized software
  • Ensure proper financial statement disclosures

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