A growing number of organizations are adopting agile practices for software development. While technology professionals eagerly embrace this trend, agile software development practices can confuse many financial professionals and external auditors.
Project and capitalization
Misunderstandings of how to track agile project costs for developing internal-use software can lead to inconsistent financial statements and have an adverse effect on an organization’s perceived financial position. Internal-use software is acquired or internally developed and there are no substantive plans to market the software externally. On the positive side, agile software development methods can lead to improved tracking of project costs associated with internal-user software. The iterative and feature-based approach when using agile methods coupled with increased interactions among team members and stakeholders provides greater visibility to agile project activities.
An incentive for appropriate capitalization of expenses for internal-use software projects is the spread of investment costs over time. This can help organizations find earlier funding for headcount or tools to more effectively deliver the software and may free up funds to explore other immediate opportunities. A common challenge faced by organizations for capitalizing agile projects is appropriately classifying costs into the different stages of computer software development – preliminary project stage, application development stage, and post-implementation/operation stage. Without knowledge of agile practices, it may be difficult for financial leaders to understand activities and individual roles of persons within agile teams to decide how to account for project costs. It may also seem difficult to apply accounting standards to agile projects when the standards seem oriented more towards traditional software development methods.
The involvement of both financial leaders and technology professionals within an organization is critical when creating or updating your organization’s statement of position with respect to capitalization. Both perspectives are needed to clarify the different types of costs incurred during agile projects and to evaluate whether costs are eligible for capitalization in accordance with generally accepted accounting principles (GAAP).
Effects of capitalizing vs. expensing include the following:
- Net income – Capitalizing costs results in a smoother pattern of reported incomes and higher profitability in initial year than if expensed.
- Stockholder’s equity – Expensing results in lower stockholders’ equity in initial year.
- Cash flow from operations – Capitalizing costs can result in higher net income in the initial year, as the cash expenditure would reduce the cash flow from investing activities, but expensing has a larger effect on cash flow from operations in the initial year, as it would directly reduce net income.
- Assets reported on the balance sheet – Capitalizing costs shows higher total assets.
- Financial ratios – Capitalizing costs will display higher profitability and equity ratios early with lower ratios in later years. Operational-efficiency ratios (e.g., asset turnover) are lower under capitalization method because of increased assets.
- Matching principle of accounting – Being able to match expenses with period of benefit. Audits can be challenging and an expensive endeavor if you do not prepare in advance. Be prepared to answer the below key questions related to capitalizing software and also be ready to provide the auditors documentation that supports your answers.
- Are capitalized costs for projects eligible?
- Were assets placed into service and amortized appropriately?
- How was the useful life determined?