1. What does capitalization mean?
Capitalization means recognizing an expense as an asset for long-term use and gradually showing it as an expense (through depreciation or amortization). For example:
- If a company creates new software that will be used for several years, its cost can be capitalized.
- But if it is just a routine upgrade or maintenance-related expense, it is recorded directly as an expense.
2. When can software development costs be capitalized?
For the cost of software to be capitalized, it is essential that it is an asset that will provide benefits in the future.
Capitalizable software costs:
- New software development
- Custom software creation (which is necessary for the business)
- Major changes in existing software (that add new features and capabilities)
- The costs of research and development for software (R&D Costs) are considered as expenses when the software is proven to be technically feasible.
Expenses
- Costs of initial research and brainstorming (when it is not clear whether the software will be developed or not).
3. Accounting Rules on Software Costs in India:-
Indian Accounting Standards (IND AS) and Tax Rules:
In India, Accounting Standard 26 (AS 26) and Ind AS 38 (Intangible Assets) determine when software development costs can be capitalized.
According to AS 26:
- Software is an intangible asset, so it can only be capitalized if it will provide future financial benefits.
- If the cost of purchasing or developing software is capitalized, it can be amortized for up to 5 years.
According to the Income Tax Act (Section 32):
- Depreciation of up to 40% can be claimed on software.
4. Advantages and Disadvantages of Capitalization:-
Advantages of Capitalization:
Increased Profit – If the cost of software is treated as an immediate expense, it will show higher spending in one year, potentially reducing net profit. However, capitalization spreads the cost over several years, which does not affect profit.
Tax Benefits – Tax savings can be achieved through depreciation and amortization on capitalized expenses.
Assets appear on the balance sheet – This improves the company’s net worth and asset value.
Disadvantages of Capitalization:
More complex accounting – It needs to be recorded correctly, which can be difficult for small businesses.
Impact on liquidity – Proper cash flow management is essential as costs are spread over several years.
5. Important suggestions for companies:-
- If you are purchasing software or having it custom developed, first determine whether it will function as a business asset or just a service.
- If the software will be used for several years and will provide financial benefits, it makes sense to capitalize it.
- If the costs are for minor improvements, upgrades, or routine maintenance, it is better to consider it an expense.
- Consult a professional chartered accountant considering accounting and tax benefits.