IT Value

Software Expensing Grows, Study Finds

Technology firms fear that carrying development costs on their balance sheets could diminish future earnings and threaten their share prices.
David KatzDecember 16, 2010

Falling in line with a recent trend to more conservative cost accounting, software companies are recording more product-development expenses immediately rather than booking them over time, new research suggests. The reason? Having suffered the consequences of past write-downs, they’d rather not risk the consequences of future ones.

In a study of 100 of the biggest publicly held software companies, the Georgia Tech Financial Analysis Lab found that 71% recorded all their software-development costs as research and development expenses on their income statements during 2009. To be sure, that result is in line with the 70.5% number seen in the lab’s study of software cost accounting in 2006.

The remaining firms studied reported at least part of their software-development costs as a capital expense on their balance sheets. The average rate of capitalization (capitalized costs relative to total software costs incurred) slipped to 15% last year from 20% in 2006, however. “Generally, we’re seeing a bit more expensing now than four years ago,” says Charles Mulford, director of the lab and professor of accounting at Georgia Tech.

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While the decline isn’t statistically significant, “software firms are showing more of an overall preference for expensing” development costs rather than assuming them as capital assets and incurring them over time, contends Mulford.

In the past, many of the technology firms that carried estimated software-development costs on their balance sheets found after a number of years that those costs had not boosted the firms’ assets as much as they had expected. At that point, the firms had to write those costs down as an immediate expense on their income statements, thereby diminishing their earnings and threatening their share prices.

Software executives may be learning from history. In their current survey, the Georgia Tech researchers found many fewer impairment charges in 2009 than they did in 2006. “In an effort to avoid the risk of an impairment charge, [software executives] might have erred on the side of being conservative, and expensed these costs,” says Mulford.

Current Financial Accounting Standards Board guidelines require that all costs incurred before a product reaches “technological feasibility” — the point at which it can actually be produced — must be treated as R&D expenses. After that, companies can capitalize costs associated with software development until the product is released. Once that happens, the capital expenses are amortized.

Deciding how much of development outlays to treat as capital costs rather than R&D expenses is important because as “capitalization rates increase, [companies’] current earnings are raised and future earnings are lowered,” says the research report.

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