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Business Reporting

A Strategic Guide to R&D Capitalization for SaaS Companies

Published on July 9, 2024
Joe Garafalo

Founder and COO

The question of whether to capitalize or expense your R&D costs is a SaaS accounting riddle for the ages. While recent changes to IRS section 174 mean you must capitalize and amortize R&D spending for tax purposes, it’s still theoretically optional for financial reporting purposes.

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Read on to learn the difference between expensing and capitalizing R&D costs in your financial statements, and when one makes more sense than the other.

What Is R&D Capitalization?

R&D capitalization is the practice of recording R&D expenses as an asset on your balance sheet, rather than immediately expensing them in your SaaS P&L.

Capitalization involves, first, recognizing the R&D costs relevant to capitalization—say, the development of software (internal or external) —then amortizing the related R&D costs over their estimated useful life. Of course, only certain R&D costs can be capitalized in line with GAAP—all others must be expensed when incurred.

We’ll get more into the technical details below, but first: why capitalize?

What’s the Benefit of R&D Capitalization?

The primary benefit of R&D capitalization has to do with profitability assessment.

One of the most basic elements of GAAP is that revenue should always be matched with expenses. That being said, it can take a long time to see your software development costs turn into sales.

By expensing R&D costs all at once, you create a distorted view of your company’s profitability. That’s because the current software expense—which could be quite high—is not being matched with its future returns.

Capitalization solves this problem by transforming R&D costs from P&L operating expenses to a balance sheet asset, that is amortized and gradually written off over a longer time period.

This has the effect of boosting your reported net income and EBITDA, along with other profitability metrics like return on assets and return on equity.

But what costs are eligible to be capitalized, and how exactly do you capitalize R&D costs?

GAAP Requirements for R&D Capitalization

Software for SaaS companies can be broken down into two types — internal-use, and external use. Internal-use software is software your team uses to make their jobs easier, like a project management tools or internal applications, while external software refers to a product you’re developing to sell.

For capitalization purposes, the distinction is crucial.

GAAP Financial Statements & Generally Accepted Accounting Principles for SaaS

Identifying Eligible R&D Costs

Whether your software is for internal-use or external sale, the R&D expenditures that can be capitalized are the same. These include:

  • The cost of labor of software engineers
  • Software licenses
  • Any materials used during development
  • 3rd party development fees

So, if eligible costs are the same, why is the distinction between internal-use and external software important? Because when exactly development activities are eligible for capitalization depends on two things: the type of software (internal-use or external), and which stage of development the software is in.

Rules for Internal-Use Software

ASC Topic 350 covers capitalization rules for internal-use software. Development can be broken down into three stages.

First, we have the preliminary stage. This is the “drawing board” stage, where you’re planning out the concept and how you’ll achieve it. Any R&D activities in this stage can not be capitalized.

Next, we have the development stage. This is where you get into actual coding and testing and can begin capitalizing costs.

Finally, we reach the implementation stage. Once the internal software is fully developed and ready for use, you can no longer capitalize. Any ongoing maintenance costs, for example, must be expensed.

Rules for External (Marketed) Software

ASC Topic 985 covers capitalization requirements for external software, the development of which is also broken down into three stages.

First, any costs incurred in the planning stage are expensed. That includes prototyping, design, and analysis.

Before we move to the next phase, it’s important to understand the concept of “technological feasibility.” For software you plan to sell, “technological feasibility” is the dividing line between when you must expense costs and when you can capitalize them.

A piece of software is considered technologically feasible when you’ve determined it’s possible to create the product and can reasonably assume it will provide value to customers in the future. Typically, this means a working version.

Once you’ve achieved technological feasibility, you can start capitalizing costs in the development stage.

The final stage begins when you make your product available for sale. At this point, you can no longer capitalize R&D costs but must expense them as incurred.

SaaS products are constantly reinvented, even (and often especially) after they roll out to market. Can you capitalize development of additional features? Yes, but only before you make the product available for sale. The same goes for bug fixing.

Capitalizing R&D Costs Examples

Say you spend $500,000 on developing some internal-use software. This software is crucial to get your team up and running but, because your start-up’s still early-stage and not driving much revenue, you’re worried about the expense lowering your company’s reported profitability.

So, you decide to transform it into an asset by capitalizing these costs on the balance sheet instead of expensing them on the P&L.

You estimate the project’s useful life as 5 years, so set that as the amortization period. This makes the amortization amount $100,000 ($500,000/5), meaning each year, you’ll expense $100,000 each year for the next 5 years versus expensing $500,000 in year 1.

Of course, you’re still actually paying the $500,000 in development costs currently. As such, it will be recorded on your cash flow statement as a cash outflow.

In the meantime, the assets on your balance sheet now appear higher thanks to the increase in capitalized software.

Now, let’s say you spend $1,000,000 on a piece of software you’re planning to sell.

You follow the GAAP guidelines, which state you can only capitalize product development costs after you’ve achieved technological feasibility but before your initial go-to-market motion.

Because you use the agile approach to software development, and separate features are developed independently, there’s only a small window between when your product is technologically feasible and before you start selling it.

You realize the benefit of capitalization is immaterial in this case, so you simply expense the $1,000,000 cost on your P&L.

Should I Capitalize My R&D Costs?

The answer to this question depends on two factors: the size of the project, and the timing of certain stages in the development process.

First, capitalization isn’t necessarily easy—it can burden the finance team and slow down your month-end close. So, set a cost limit for R&D projects you look into capitalizing to avoid tracking expenses for immaterial projects.

Next, timing. Sometimes, especially if you take an agile approach to software development, the window of time in which you can capitalize costs is very small. That’s because you may be achieving technological feasibility only shortly before your product roll-out. In fact, this is the reason many large tech companies like Alphabet and Meta don’t capitalize their research expenses, as per their own reports.

It’s also important to keep in mind that capitalization is purely for financial statement reporting. Your company is not actually more profitable from a cash flow perspective. If you’re in a business where optimizing net income is important for your valuation, this can be a

Finally, there’s a point we want to highlight: capitalization does nothing in the long-term if you don’t have a solid, profitable product. You’ll have the same operating margin year after year. So, before anything else, start with a good product and a good product-market fit.

Capitalizing R&D Costs: How Mosaic Can Help

Research and development capitalization is a strategic accounting treatment that can be used to spread tax burdens out over time and increase your picture of profitability. But don’t get so caught up in appearing profitable to investors that you forget to actually become profitable!

Whether you capitalize or expense your R&D costs, Mosaic can help you track how they’re changing over time and how they’re contributing to growth and eventual profitability. Mosaic also simplifies your month-end close by centralizing data in one platform, making it easier to capitalize R&D while staying in line with GAAP.

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R&D Capitalization FAQs

What documentation is required to support R&D capitalization for audit and compliance purposes?

The most important will be payroll records and time spent on capitalizable activities like coding or testing. You’ll also need to refer to your issue history in platforms like Jira, Asana, or Linear. Finally, if selling the software, you’ll need software design documentation.

Is R&D capitalization a type of CapEx?

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