IFRS Software Development Capitalization Rules

Under International Financial Reporting Standards (IFRS), the treatment of software development costs is crucial for accurate financial reporting. The main standard guiding the capitalization of software development costs is IAS 38, "Intangible Assets." This standard outlines the criteria for recognizing and measuring intangible assets, including software.

Definition and Scope

Software development costs typically include expenses related to the creation or enhancement of software that will be used for internal purposes or sold externally. IAS 38 distinguishes between research and development phases, with different accounting treatments for each.

Research Phase

In the research phase, costs are incurred to gain new knowledge or understanding. According to IAS 38, costs associated with research activities must be expensed as incurred. This phase involves activities aimed at discovering new technologies or solutions but does not yet involve the application of this knowledge to develop a product or process.

Development Phase

The development phase follows the research phase and involves the application of knowledge gained to develop a new or improved product. IAS 38 allows for the capitalization of development costs if specific criteria are met:

1. Technical Feasibility: The entity must demonstrate that the software is technically feasible to complete and will be usable or saleable.
2. Intention to Complete: The entity must intend to complete the development and use or sell the software.
3. Ability to Use or Sell: The entity must have the ability to use or sell the software.
4. Probable Future Economic Benefits: The software must be expected to generate future economic benefits.
5. Available Resources: The entity must have adequate technical, financial, and other resources to complete the development and use or sell the software.
6. Reliably Measurable Costs: Costs attributable to the development phase must be reliably measurable.

Capitalization Criteria

If the above criteria are met, development costs can be capitalized as part of the cost of the intangible asset. This means that these costs are recorded on the balance sheet rather than being expensed immediately. Capitalized development costs are then amortized over their useful life.

Subsequent Measurement

Once capitalized, the software development costs are subject to subsequent measurement requirements. The entity must choose between the cost model and the revaluation model for subsequent measurement:

• Cost Model: Under the cost model, the software is carried at its cost less any accumulated amortization and impairment losses.
• Revaluation Model: Under the revaluation model, the software is carried at its fair value at the date of revaluation less any subsequent accumulated amortization and impairment losses. However, this model is rarely applied to software as it requires an active market for the asset, which is not common for software.

Amortization

Amortization of capitalized software development costs is based on the asset's useful life. The useful life is determined based on factors such as expected technological advancements, industry practices, and usage patterns. The amortization method should reflect the pattern in which the software's economic benefits are consumed.

Impairment Testing

Capitalized software development costs must be tested for impairment annually or whenever there are indicators that the carrying amount may not be recoverable. An impairment loss is recognized if the carrying amount exceeds the recoverable amount.

Disclosures

Entities must disclose information about their capitalized software development costs in their financial statements. This includes the carrying amount of capitalized costs, amortization methods, useful lives, and impairment losses. These disclosures provide transparency to users of financial statements about the nature and financial impact of software development activities.

Example

To illustrate the application of these rules, consider a company that develops new software for internal use. During the research phase, the company incurs $200,000 in costs, which are expensed. In the development phase, the company spends an additional $500,000, meeting all capitalization criteria. This $500,000 is capitalized and subsequently amortized over the software's useful life of 5 years.

Table of Software Development Costs

Conclusion

Understanding and applying IFRS software development capitalization rules ensures accurate financial reporting and compliance with international standards. By differentiating between research and development phases and adhering to capitalization criteria, entities can appropriately reflect the value and impact of software development activities in their financial statements.