Capitalisation of Software Development Costs under FRS 102

The Financial Reporting Standard 102 (FRS 102) provides guidelines on how entities should account for and report the capitalisation of software development costs. This article delves into the principles and practices surrounding these costs, with a focus on the specific requirements and implications for entities preparing financial statements under this standard.

Introduction

FRS 102 is the financial reporting standard that applies to the preparation of financial statements for entities in the UK and Ireland, and it includes provisions for the capitalisation of software development costs. Understanding how to account for these costs is crucial for entities engaged in software development or those investing in software projects.

1. Definition and Scope of Software Development Costs

Software Development Costs: These are expenses incurred in the creation of software. They may include costs related to design, programming, testing, and implementation.

Scope of Capitalisation: Under FRS 102, not all software development costs are eligible for capitalisation. The standard distinguishes between research and development phases and prescribes different treatments for each.

2. Research Phase vs. Development Phase

Research Phase: Costs incurred during the research phase are generally expensed as incurred. This phase involves activities aimed at gaining new scientific or technical knowledge and understanding, without a specific product or process in mind.

Development Phase: Costs incurred during the development phase can be capitalised if certain criteria are met. This phase involves applying research findings to develop new products or processes. The capitalisation of development costs depends on the ability to demonstrate that the project will be successful and generate future economic benefits.

3. Criteria for Capitalisation

According to FRS 102, for software development costs to be capitalised, the following criteria must be met:

• Technical Feasibility: The entity must demonstrate that the software is technically feasible.
• Intention to Complete: There must be an intention to complete the software and use it as intended.
• Ability to Use or Sell: The entity must be able to use or sell the software.
• Probable Future Economic Benefits: It must be probable that the software will generate future economic benefits.
• Resources: Adequate technical, financial, and other resources must be available to complete the development.

4. Measurement and Recognition

Initial Measurement: Costs that meet the criteria for capitalisation should be measured at their cost. This includes direct costs such as salaries of employees directly involved in the development process and other directly attributable costs.

Subsequent Measurement: After initial recognition, capitalised software development costs are typically carried at cost less accumulated amortisation and impairment losses.

Amortisation: The amortisation of capitalised software costs should be done on a systematic basis over the useful life of the software. The useful life should reflect the period over which the software is expected to be used.

Impairment: Regular reviews should be conducted to assess whether there are any indications that the software may be impaired. If the carrying amount exceeds the recoverable amount, an impairment loss must be recognised.

5. Disclosures

Financial Statements: Entities must provide disclosures in their financial statements that include the accounting policies adopted for software development costs, the amount of costs capitalised during the period, and the amortisation methods used.

6. Impact on Financial Reporting

Balance Sheet: Capitalising software development costs affects the balance sheet by increasing the value of intangible assets. This can enhance the company's asset base and affect financial ratios.

Income Statement: While capitalisation delays the recognition of expenses in the income statement, it results in amortisation charges over the useful life of the software, which impacts net income.

7. Case Studies and Examples

Case Study 1: Software Development by a Tech Firm: A technology company developed a new software application for internal use. The development costs met the capitalisation criteria. As a result, these costs were capitalised and amortised over the expected useful life of the software.

Case Study 2: Capitalisation vs. Expensing: Another entity developed software but faced technical difficulties that delayed completion. Since the project failed to meet the capitalisation criteria, the costs were expensed as incurred.

8. Conclusion

Understanding the capitalisation of software development costs under FRS 102 is essential for accurate financial reporting. By adhering to the criteria and guidelines, entities can ensure compliance with accounting standards and provide a clear picture of their financial position.

References

• FRS 102: The Financial Reporting Standard applicable in the UK and Republic of Ireland.
• International Financial Reporting Standards (IFRS) for comparison.