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February 24, 2003 08:46 AM

Categories: Operations and Legal

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Joined: 06/10/2002

What are your thoughts on handling the accounting of software development costs?

  • Do you expense the costs (primarily labor)?

  • Do you capitalize the costs (some fraction of the total labor)?

  • If costs are capitalized, what criteria do you use when determining what's an expensed cost and a capitalized cost?
    I can imagine putting systems in place to track a "capitalizable" expense, but how to stay consistent in interpretation?
    In my company's situation (a start-up), our accountant has suggested capitalizing a fraction of the labor costs for 2002 as I know our 2002 code will be useful into 2004. But whatever we end up doing, I want it to be consistent in practice and theory from year to year.
    Your experiences?

  • Discussion:    Add a Comment | Comments 1-8 of 8 | Latest Comment

    February 24, 2003 10:17 AM

    Shaver's right -- private companies, most of which look at an acquisition as their only realistic exit strategy, should not capitalize R&D. I.e., the question about what passes tax muster this year is only a small part; it's important to play out the scenarios in 2, 3, and 5 years to see what makes the most sense.

    February 24, 2003 11:14 AM

    I appreciate your replies to my questions. I hadn't been thinking about implications to a future acquisition of the company.

    Interesting that in a report to the American Accounting Association in 1998 on "The Value-Relevance of Intangibles: The Case of Software Capitalization" the finding was:

    We also find that investors undervalue firms that expense all their software development costs.

    But still, as a software company, it's hard for me to ignore that future benefits will come from our investment in writing code in 2002 (and so on), yet our balance sheet shows only the costs of PC's, servers, etc.

    Anyone care to reply to this opinion of Baruch Lev, the Philip Bardes Professor of Accounting and Finance at New York University's Stern School of Business, when he says:

    "Conventional accounting performs poorly with internally generated intangibles such as R&D, brands, and employee talent┬?the very items considered the engines of modern economic growth. Example: Today's generally accepted accounting principles call for the immediate expensing of R&D costs. But, unlike rent and interest payments, intangibles often produce rich future rewards. Why else would firms invest so heavily in them? Expensing them now produces serious distortions in reported earnings and detracts from the relevance of financial reports.

    "Many defend immediate expensing because it is conservative (i.e., a practice that leads to the reporting of lower profits). But, in fact, it is biased and inaccurate. Expensing is only conservative when outlays on intangible investments exceed their revenues, which usually occurs early in a company's life. Later on, as investment in intangibles subsides while revenues from intangibles increase, reported profitability is often overstated."

    Professor Lev goes on to describe the 4 common criticisms of capitalizing intangible assets and addresses each one. For more see:

    February 24, 2003 12:00 PM

    I hadn't been thinking about implications to a future acquisition of the company.
    You should! I cannot emphasize this too much to the entrepreneurs reading this list. DO EVERYTHING WITH A VIEW TO HOW IT WILL AFFECT THE FUTURE ACQUISITION OF YOUR COMPANY. Even if you in fact NEVER sell, the exercise will have benefited you, and if you DO sell, which you probably will, then every "didn't think about it" along the way will haunt you painfully.
    Conventional accounting performs poorly with internally generated intangibles ...
    I would say "get used to it." Conventional accounting is old. Someday perhaps someone will invent a new way of accounting that better reflects what we do. What are your MOST VALUABLE assets? Many entrepreneurs would point to the assets that go home every evening after work. But they aren't on your balance sheet at all. Ditto for your "brand" and "market franchise," which I would guess are actually your most valuable assets.

    The experts you quote are probably much more expert than anyone reading this forum. The fact that there is conflicting advice out there means that you pays your money and you takes your choice.

    When software companies are acquired, the price paid is usually based on a formula that has NOTHING to do with your balance sheet. In accounting terms, you will be paid a price in excess of your book value, called "good will." (No relationship to what non-accountant call good will.) If your book value is higher, you will still get the same price, but the accounting for it will be different.

    Generally, as a small business, you want to maximize your cash flow and minimize your profits (taxes). Capitalizing costs does nothing for cash and increases profits (taxes). You pay ordinary income tax now rather than eventual capital gains tax, at roughly half the rate.

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    Discussion:    Add a Comment | Back to Top | Comments 1-8 of 8 | Latest Comment

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