Accounting & Tax

Software Capitalization Clouds Comparisons

Although many companies expense their software development costs, according to a new study, differences in accounting approaches can give ''the imp...
Helen ShawMay 26, 2006

Fewer than 30 percent of software companies capitalize their development costs, according to a new study. But the companies that take a less conservative accounting approach and capitalize those costs do so at a high rate and make cross-industry comparisons difficult, says accounting professor Charles Mulford of the Georgia Institute of Technology.

Mulford, who conducted his study on “Capitalization of Software Development Costs” with MBA student Jack Roberts, reviewed the financial filings (generally from fiscal 2005) of 207 companies that develop software. Only 61 companies capitalized software development costs, they found, at a mean rate of 20 percent; about one-third of the companies capitalized those costs at a higher rate, with the highest at 82 percent.

The professor observes that the applicable rule from the Financial Accounting Standards Board (FAS 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed) gives companies great discretion over whether to expense or to capitalize their costs of software development, and by how much. Companies that take the conservative route and expense those costs consequently reduce their operating cash flow, according to Mulford. Companies that take a more aggressive approach and capitalize some costs, he continues, raise their income and assets in the current period and lower their income in future periods. The higher the rate of capitalization, the better for earnings.

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Typically, the study found, companies that capitalize these costs record them in the investing section of the statement of cash flows rather than the operating section, and so have a relatively higher operating cash flow. The software industry’s approach to capitalizing these costs is so inconsistent and its effect on company-to-company comparisons so great, maintains Mulford, that “you get the impression those that are capitalizing are doing better financially.”

Indeed, when the researchers adjusted the cash flow of the companies that capitalized software development costs by moving them from investing section to the operating section of the statement of cash flows, the adjustment to operating cash flow was as high as 159 percent.

The study also found that capitalizing development costs can allow impaired assets to remain on the balance sheet, perhaps because the amount capitalized is too great or the rate of amortization, too slow. Whether write-downs eventually must be taken due to aggressive accounting or to the vagaries of the software industry, the study cautioned, is less important than “the fact the they do happen with significant frequency and impact.”

The most surprising finding, observes Mulford, is how many companies chose to expense their software development costs, which makes comparing companies far easier. But for the companies that capitalized costs, he added, “the percentage of the total capitalized seemed high.” One solution suggested the study, would be for FASB to consider revoking FAS 86 and treat all these costs as research and development, which would be expensed. “This step would seem to be more closely aligned with the realities of the software industry today,” concluded the study, and it would “have the side benefit of improving comparability among software companies.”