The reality is that enterprise software purchases are complex. The purchase process can be long and drawn out and include dozens, if not hundreds of factors. When it comes to making decisions around which solutions to go with, technology and technological capability are merely one subset of these factors. How to pay for new software is another and equally important element of a purchase decision you should keep in mind as well.
However, it may be that the arrangement you describe is one where you purchase a perpetual license, and then the vendor hosts the software for you. In that case then, yes, the licenses can be capitalized as software, to be written down over your standard period for software licenses (I've seen ranges of 3-5 years for software, depending on the nature of the software).
This is especially the case when it comes to today’s software landscape. The cloud and SaaS have created new purchase options beyond traditional owned perpetual software licensing. This in turn has also opened up new options when it comes to the financing models used to pay for software that buyers can now consider.
You’re probably not an accountant and may only have a modest understanding of the benefits of accounting for technology investments as an operational expense versus a capital expense. As such it can be difficult to fully articulate the potential financial implications and benefits of using one or the other to account for their technology investments when vying for internal budgets and approvals.
Here is a very basic overview.
CapEx vs. OpEx
Capital expenditures cover any major investments in goods which will show up on an organization’s balance sheet. Any long term assets such as property, infrastructure or equipment (including owned software licenses) are considered capital expenditures and from an accounting standpoint must be depreciated over the life of the asset to reflect their current value on the balance sheet. This is typically calculated over a period of 3 to 10 years.
Operating expenditures, on the other hand, show up on a completely different set of accounting reports. These costs are included as part of your company’s profit and loss. That’s because operating expenses are related to expenses that will be incurred on an ongoing basis. Some people refer to these expenses simply as the cost of doing business.
Shifting capital expenses to operating expenses can be a clever way for organizations to stretch their budgets – at least from an accounting standpoint. This accounting flexibility is now an option for software purchases thanks to SaaS.
The table below summarizes and compares the two.
Benefits of OpEx
In these challenging economic times, many organizations are in the pursuit of maintaining a lean balance sheet to preserve cash flow. As a result many organizations, including yours, may be paring back or freezing new CapEx investments, opting instead wherever possible to fund projects from OpEx budget. From a technology perspective, these decisions on what should or should not be a capital asset are also influenced by the rapid changes inherent in modern technology. New hardware runs faster, uses less energy and provides more cores every year, likewise SaaS platforms often employ rapid upgrade cycles with a constant influx of improvements. In that context it doesn’t make sense to sink money into technology that could be obsolete by the very next model.
Moving software purchases to a more flexible SaaS model and the resulting flexibility in how an organization can account for these tools as an OpEx versus a CapEx is one of the many advantages that the cloud has brought to many organizations. Using your OpEx budget is a great way to help your organization do more with less. Less headaches from unexpected hardware failures, less headaches from software patches gone wrong, and ultimately less headaches for your accounting team as well. It’s a win-win, for you, for your CIO and your CFO as well.
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Gaap Capitalization Of Software Licenses
'Capitalizing' a cost allows a business to report that cost as an asset rather than an expense. Not only does this boost the company's value by putting more assets on its balance sheet, it also boosts the company's profit by reducing expenses. Corporate financial accounting follows U.S. generally accepted accounting principles, or GAAP. These principles include guidelines on what a company can capitalize and how it does so.
Capitalization vs. Expense
When companies incur costs, they can either 'capitalize' those costs or 'expense' them. Capitalizing a cost means converting it to an asset on the balance sheet. For example, if a company pays $10,000 in cash for piece of equipment, its financial statements don't show that it 'spent' $10,000. Rather, they show that it converted $10,000 worth of cash into $10,000 worth of equipment, an asset. Expensing a cost, on the other hand, means reporting it on the income statement as an outflow of money. If a company pays $10,000 for rent, for example, its financial statements show that money as being 'spent.' Expenses directly reduce a company's net income, or profit, so the more costs a company can capitalize rather than expense, the greater the profit it can report to shareholders.
Software Capitalization Rules Fasb
Definition of an Asset
GAAP defines a company's assets as the things it owns or controls that have measurable future economic value. If something doesn't fit that description, it can't be capitalized. Land, buildings, equipment, items held in inventory, stocks and bonds, even IOUs from customers (accounts receivable) have measurable future economic value, so a company can capitalize them as assets. Other costs, such as advertising, marketing and research and development, must be expensed. While these costs are certainly intended to produce future value, that value can't be reliably measured at present.
Gaap Accounting For Software Purchases
What to Capitalize
GAAP allows companies to capitalize the full costs of acquiring an asset and preparing it for use. Suppose a publishing company buys a $5 million press from a manufacturer in Germany. Not only can the company capitalize the purchase price of the press, it can also capitalize the cost of transporting the equipment from Germany. Assembly costs, the cost of any necessary modifications to the company's printing plant, even taxes and tariffs paid on the presses, can all be rolled into the capitalized cost. On a far smaller scale, if a company buys $100 in stock for investment purposes and has to pay a $1 commission, it can capitalize the full acquisition cost: $101.
Depreciation
What Is Software Capitalization
When a company capitalizes an asset, that doesn't necessarily mean it will never have to expense the cost. 'Hard assets,' such as property, plants and equipment, tend to lose value as time passes. Buildings deteriorate, vehicles and equipment break down, technology becomes obsolete. GAAP recognizes this and it requires companies to expense a portion of the asset's value for each year of its useful life. This is called depreciation. A $5 million printing press, for example, might have a useful life of 25 years, at the end of which it would be worth, say, $200,000 for scrap metal. So the company has to depreciate $4.8 million worth of value over 25 years. Under the most common depreciation method, the company would claim a depreciation expense of $192,000 a year. Depreciation also serves a second purpose under GAAP: the 'matching principle.' This principle says that when companies report revenue, they must simultaneously report, as expenses, all costs incurred in producing that revenue. For the printing press, the $192,000 in depreciation is an expense incurred to produce the revenue generated by the press that year.
- 'Financial Accounting for MBAs,' Fourth Edition; Peter Easton et al; 2010
Capitalization Of Software Implementation
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