If your company is unable to find off-the-shelf software that meets its needs, you may have employees or contractors building custom software. Purchased software is capitalized (made into an asset) and depreciated, and so can internally developed software as long as it’s true new development and not bug fixes or ongoing maintenance work.
This blog is about going back to the basics in accounting, and the objective of the post is to walk you through the correct way to book a capitalized software journal entry.
The trickiest part of the capitalized software journal entry is the data gathering. Getting the data from contractors is easy – ask them to invoice you and segregate development work from bug fixes and ongoing maintenance. As for getting data from your employees’ work, some companies choose to have engineers track by hour what they’re working on. Other companies may meet with engineering management periodically (i.e., quarterly) and ask for estimates by employee. Some companies get savvy and get their data from the data the engineers already use, perhaps from “story points” if the team engages in “Agile” development. Now apply weighted (employer tax + benefits) salary rates to the engineer’s development time.
Journal: Capitalized Software
Frequency: Each reporting period (i.e. monthly)
FloQast folder location (learn more about FloQast folders): ‘Fixed Assets’ is where software sits, and so can capitalized software. Just make sure engineer salary information isn’t available to any general ledger accountant or others who wouldn’t otherwise need this information.
The dr.’s and cr.’s
|6/30/17||Internally developed software asset – Project XYZ||$42,375|
|Internally developed software asset – Project ABC||$15,000|
Memo: To capitalize software internally developed during June 2017
|Accumulated depreciation, internally developed software||$1,584.00|
Memo: To record June 2017 depreciation of internally developed software asset
What else do I need to know?
- Capitalizing software does take a lot of time to calculate and document, but there are real benefits to the company’s bottom line. Salary expense that would have otherwise been an immediate hit to net income can now to spread out over time thanks to depreciation.
- If the company is an income tax payer (profitable) there is an R&D credit from the IRS. There are also new payroll tax credits for companies that are relatively young and don’t have gross receipts over a certain threshold. Your journal entries and underlying documentation will help your tax preparer make a claim for this real cash back.
Reconciliation (click here for 3 best practice Excel reconciliation templates)
- Keep a running list of additions and disposals by project
- Roll forward your net asset balance: Additions – depreciation – software decommissioned = new net asset balance
- Not crediting a contra expense assets: Yes, we’re removing salary expense from your income statement. But remember you’ll always want to have salaries expense as a debit to wage expense at gross in your trial balance. Use a “contra” expense called “development” to make those credits (reductions) to expense.
- Not capitalizing assets by the “product” or “project.” You may want to add internally developed software assets to your fixed asset register in chunks like “all the software we developed during June 2017.” But there may be different software projects mixed up in there. If a project were ever decommissioned, you will need to dispose of this asset. Make sure your data straight from the beginning can specify a “project.”
- Not enough documentation! Auditors reviewing GAAP financials or the IRS reviewing R&D tax credits, may disallow the capitalization if there isn’t sufficient documentation. Have your engineering management create a quarterly “narrative” in common language of what exactly was actually built that period. And make sure as accountants we have documentation to allow an auditor to trace from an engineer’s time straight through to the journal entry!
How auditors audit
- Auditors will ask for your fixed asset register. Then they’ll ask for the invoices, but there aren’t invoices for employee-developed software! So you’ll provide them with the “narrative” of what was built for a general understanding, the underlying details like engineer’s hours coded to projects, and a salary listing for recalculation.