Preface: Proper accounting for customized software costs is becoming increasingly relevant to entrepreneurs. This blog is make the complexity understandable for business owners.

Computer software is becoming increasingly relevant to more smaller businesses and entrepreneurial financial management teams. From CRM modules to customized accounting systems and automated inventory controls, trends with reliance on customized business and industry software continue to climb. For chief financial officers, this requires appropriate knowledge of accounting for the costs incurred on the purchase and investment in licenses and programming fees from vendors; and for IT programmers, questions on revenue recognition.

For programmers involved in method development, or customized software programming on computer systems that require significant production, modification, or customization, the accounting for revenue should be on a contract basis; either percentage of completion or complete contract. Typically, this is tracking of estimated hours on programming to hours incurred, and the measure of the percentage of projection completion is accrued to revenue on current project billings.

For companies investing in internal-use software, the decision to capitalize or expense depends mostly on the nature of the cost incurred, and more specifically on the state of the incurred costs, i.e. preliminary project, application development, or post-implementation/operation state. When upgrading software, external costs in the preliminary project states or post-implementation should be expensed, while application development costs should be capitalized.

When capitalizing costs for internal use software, the types of expenses eligible are say fees paid to third-party developers, costs paid to obtain the third-party code, and travel expenses associated with the software development, along with payroll and employee benefits for time devoted to the internal-use software. In addition, this includes any interest expense to finance the associated above costs. General and administrative expenses should be expensed; say rent, utilities, and office supplies.

Now let’s say your business doesn’t have software programmers on staff, or you don’t hire third-party developers. Instead, you purchase software for internal use prepackaged. In these instances, the cost often includes the software license, along with training, maintenance, data conversion, and rights to future upgrades. Again, in these scenarios, the cost of the software should be allocated among all individual elements relevant to the purchase. Namely an expensing of training costs, with an amortization of the license fee or application.

Typically, software amortization is for a period of 36 months for IRS purposes. Therefore, investing $12,000 in customized software features for your business, your capitalized investment would be realized in say three years. Training, on the other hand, can be expensed when incurred.

This blog is not intended to be construed as tax or accounting advice. It is simply for educational purposes on accounting methods applicable to software costs. Talk with your CPA before making any accounting or tax decision relevant to your business.