A Detailed Guide to the Amortization of Software Development Costs

Software development it’s a good concept in today’s technology-driven business world. It is a great way to launch new products in the market, enhance user experience, and automate operations. However, the costs of developing such software can be substantial. Therefore, it is crucial to amortize or spread out the overall expenses of development through the software’s useful life. 

Doing so helps software owners to easily comply with taxes and accurately report finances. Entrepreneurs must understand the process of amortizing software development costs in today's corporate era as it can be a helpful approach in aligning the financial strategy and optimizing the long-term value of the software.  In this article, we have discussed our detailed guide to help first-time software developers amortize their overall expenses.

But before we proceed, let us dive deeper into the definition of amortization for clearing concepts.

What Is Amortization?

The process of amortization can be defined as spreading out the overall cost of software over a particular time.  Rather than paying the entire cost of development at once as a huge amount, the overall budget is divided into smaller chunks and paid gradually within a few years.  This step is considered helpful for business owners or professionals how to handle large expenses easily by paying a particular amount at the time when the software performs a specific job.

For instance, a software development company that has created a huge software asset, and divided the overall development cost over five to seven years. The development company can as a result pay one portion every year to complete the payment without getting into debt of huge payments. Amortizing the overall expense over the years also helps to understand the accurate value of the software over time.

Why Amortize Software Development Costs?

Software development can be an extravagant process, where expenses can be higher for customized solutions. As the market of today is fiercely competitive, building software requires a huge investment for many.  Below, you have mentioned a few prominent reasons why amortizing development costs is considered crucial.

• Matching Principle

It is an accounting principle where the generated revenue is matched with the overall investment. Here, amortizing helps to align the cost of development over the duration where the software provides value.

• Thrifty Expenses

Amortization is a great way to smooth out the extravagant costs over time. It helps to keep away from huge financial statements in a single year and spread it out over multiple financial statements.

• Tax Benefits

According to some tax regulations, business owners can easily amortize software development costs as it helps to provide potential tax savings.

When to Amortize Software Development Costs

Developers must know that every software development cost is not considered eligible for amortization. According to the standard rules of accounting, professionals must understand the difference between capitalizable costs and non-capitalizable costs. It means, the costs that can be easily capitalized and vice versa.

• Capitalizable Costs

These costs are the ones that are incurred during the development phase of software.  It consists of different technical works like coding and testing that are considered mandatory for functional software products. These expenses are easy to amortize over the software's useful life.

• Non-Capitalizable Costs

these are the costs that are during the pre-development phase of software.  It includes the conceptualization, research, and planning of the software. These expenses cannot be amortized because they are incurred during the period. 

Mostly, as soon as the project reaches the development stage, the software companies start to capitalize on the costs. Once the software is launched and ready to use, amortization takes place.

Methods of Amortizing Software Development Costs

There are multiple methods through which the software development costs can be amortized. The two most popular of these methods are known as straight-line amortization and accelerated amortization.

Straight Line Amortization

The easiest and most straightforward method of amortizing software development costs is known as the straight-line method. Here, overall expenses are evenly spread out across the soft year's useful life. According to experts, this method assumes that the software product will be able to provide consistent value throughout the period.

Example

An XYZ company spends an overall amount of 100K U.S. dollars in the development of software and considers its useful life to be approximately 5 years. According to the straight-line method, the amortization cost over the five-year duration will be 20K U.S. dollars every year.

Annual Amortization = Total Cost/Useful Life 

Accelerated Amortization

The second method, known as accelerated amortization is the process in which software companies write off the huge portion of development cost during the early years, or the ones considered as duration of higher value. This type of amortization is mostly considered when the software product is considered to lose its value over time.

Example

An XYZ company develops a software project,  where they consider its overall value to decline 40% during the first 12 months and a further 20% during the following three years,  then the amortization value would be divided into different portions. Here, the first year will have a huge amount from the overall expenses whereas the next three years will include smaller portions of the development cost.

Factors Affecting the Amortization Period

Determining the accurate period of amortization is necessary for generating a transparent financial report. Below are a few factors that influence the software's useful life and the duration through which the costs should be amortized.

Type Of Software

• Custom Software

Mostly, custom-built software products are amortized over three to five years. However, it majorly depends on the complexity and longevity of the software product.

• Off-The-Shelf Software

for off-the-shelf software products, the product's useful life duration may be considered shorter.  This is because such products have more frequent releases of updates and new versions.

Technology Changes

A software useful life can be negatively impacted due to the rapid advancements in today's technology. In case software becomes outdated due to advancing technologies, the company is forced to adjust the amortization amount accordingly.

• Software Upgrades and Enhancements

In case a software company frequently upgrades the software or adds new features, its useful life will extend as a result. In response, the amortization period will be impacted too. 

• Maintenance Costs

Basically, maintenance costs are considered non-capitalizable assets, yet, the constant upgrades and changes in the software can impact the amortization timeline.

The Takeaway

The amortization of software development costs Is a financial strategy through which the overall expenses of the development of software can be spread out evenly over a particular duration considered as the software's useful life.  Once, development companies can align the overall cost appropriately, paying these heavy expenses can become easier.