Capitalising software and development costs
When a client may capitalise money spent developing software or a new product under IAS 38, when it must be expensed as research, and what never qualifies.
By Achekam · · 5 min read · For Accountants & audit firms in South Africa, Nigeria, Kenya
A software start-up in Nairobi spends most of its first two years paying developers to build a product. A Johannesburg engineering firm spends a year designing a new irrigation controller. A Lagos fintech pays an agency to build its customer app. In each case the founders want the spending on the statement of financial position as an asset, because it is the most valuable thing the business has built and because expensing it makes the company look like it is losing money.
Sometimes they are right. IAS 38 allows some development spending to be capitalised, but sets a series of tests that much early-stage spending fails. This article covers what IAS 38 treats as an intangible asset, the research and development split, the items that never qualify, and how to correct and describe the result.
What IAS 38 treats as an intangible asset
IAS 38 defines an intangible asset as an identifiable non-monetary asset without physical substance. It is identifiable when it is separable or when it arises from contractual or other legal rights. The examples IAS 38 gives include computer software, licences, trademarks, patents, films, copyrights and import quotas.
Meeting the definition is only the start. Under IAS 38, expenditure on an intangible item is recognised as an expense unless three things are true: the item meets the definition of an intangible asset, it is probable that there will be future economic benefits from it, and its cost can be reliably measured. All three must hold. Software a client builds for its own use or for sale can meet the definition; whether the spending on it can be capitalised depends on the stage and the evidence.
Research always expensed
IAS 38 is blunt about research: research expenditure is recognised as an expense. There are no exceptions to argue about.
The practical work is telling research apart from development. Research is the stage where the client is exploring: investigating whether an idea can work, comparing possible approaches, building prototypes to learn what is feasible. For the start-up, the months spent testing whether its matching algorithm could work at all are research. For the engineering firm, the experiments with different sensor types are research. If a project cannot yet show which design it is building and that the design can be made to work, it is still in research, and its costs go to profit or loss.
Development meeting the criteria
Under IAS 38, development expenditure that meets specified criteria is recognised as the cost of an intangible asset. The criteria are set out in the standard and should be read in full; they are demanding by design. In practice, a reviewer will expect the client to be able to show evidence such as:
- a defined product or system that the team is building, beyond the exploratory stage;
- technical evidence that it can be completed and will work;
- the intention and the means, financial and technical, to finish it;
- how it will generate benefits, whether through sales to customers or use in the business;
- records that capture the costs of the development work separately and reliably.
That last point is where many small clients fall down. Developers who work across research, development and support without timesheets make it impossible to measure the cost of the development stage reliably. Without that, the cost test fails, and the spending is expensed regardless of how promising the product is.
Capitalisation starts only from the point the criteria are met. Spending before that point, even on the same project, stays as an expense; resist any request to reinstate it later because the project went on to succeed.
Internally generated brands and customer lists
IAS 38 rules out some items entirely. It states that internally generated brands, mastheads, publishing titles, customer lists and similar items are not recognised as intangible assets, and that internally generated goodwill is not recognised as an asset.
Clients often try to capitalise exactly these: the cost of building a brand through advertising, the cost of building a customer database, the time spent establishing the business's reputation. However valuable they are, they stay off the statement of financial position when generated internally. The marketing campaign that launched the fintech's app is an expense, even if the app itself is capitalised. Hardware is different again: the laptops and servers the developers use are property, plant and equipment, covered in capitalising laptops and servers.
Policy, note and adjusting entries
A worked example in words. The start-up has capitalised all developer salaries since founding. The preparer reviews the project records and finds that the product design was settled and proven technically feasible part-way through the second year, with time records kept from then on. Salaries before that point are research and early-stage work; they are moved from the intangible asset to profit or loss. Salaries after it, supported by time records, meet the criteria and remain capitalised, together with directly attributable costs of the development work.
In Achekam's Studio, such corrections are posted as year-end adjusting entries against the client's trial balance. An entry that later proves wrong is reversed with a record of who reversed it and why, never deleted. Note also that Achekam does not calculate depreciation; it presents the charges in the trial balance and flags where the depreciation charge does not agree with the movement in accumulated depreciation, so the amortisation of any capitalised development, once the asset is available for use, has to be worked out and recorded by a person. That subject is covered in amortising intangible assets.
The Studio includes standard accounting policy wording based on IFRS for SMEs, labelled for review before issue, and staff can write the client's own. A development policy should state when the client begins capitalising, what costs are included and how they are measured. Notes take their figures from the mapped trial balance; the narrative on judgements made is for a person to write.
The IFRS Foundation's IAS 38 page summarises the criteria for recognising and measuring intangible assets and the disclosures required. Ask any client capitalising development for its time records first; if they do not exist, the conversation about capitalisation is usually over.
General guidance only, not advice on your own circumstances. Tax and payroll rules change: check the current position with the authority or your adviser.
