Guide on How to Book Capitalized Software Costs Journal Entry

Introduction 

Software is an integral part of every business these days; and it is nearly impossible to operate without a robust tech stack in a technology-dependent world. As a result, companies must carefully assess the accounting treatment for software costs to ensure accurate financial reporting.. 

Accounting treatment for software depends on various factors: whether the software is for external or internal use, whether it is off-the-shelf purchased software or internally developed, and its development stage. Based on this, costs will either be expensed or capitalized. 

In this blog, we are specifically going to focus on capitalized software costs and how businesses can effectively book a journal entry for the same to ensure financial accuracy.

What Software Costs Qualifies for Capitalization?

To understand capitalized software costs better, we first need to understand the different scenarios where software costs are capitalized. The accounting treatment differs for each situation as per accounting standards such as Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS). 

1. Purchased software for internal use: The cost of purchased software is capitalized and subsequently amortized on the balance sheet. 

2. Developed software for internal use: In this case, the accounting treatment differs at different stages of the software production and use. 

1. Project stage: At this stage, the company evaluates vendor proposals and researches all its options to get started. All the costs incurred during this stage of the project are expensed. 
2. Development stage: This stage involves the actual development of the software. All the costs for coding, testing, programmer compensation, travel expenses, and contractor compensation are capitalized. 
3. Implementation stage: Once the software is ready for use and is implemented, any costs related to  maintenance and training are expensed. 

3. Developed software for external users: In this case as well, the software costs are  capitalized and expensed at different stages.  

1. Pre-technological feasibility: At this stage, the company is involved in research and development, and all the associated costs can be expensed. 
2. Technological feasibility: Once the software is through the research and development but not yet ready for sale, the company can capitalize on all the associated development costs. 
3. Availability for sale: When the software has been fully developed and ready for sale, all the additional costs incurred, including maintenance, training, customer support, etc., are expensed. 

What is a Capitalized Software Journal Entry? 

A capitalized software journal entry is a record of software development costs and involves  transactions such as programmer compensation, contractor costs, and costs associated with coding and testing. This applies to  software developed for both internal or external use.These costs are capitalized on the balance sheet and are amortized over the software’s  useful life. 

The key thing to consider when it comes to capitalized software journal entry is data collection. With numerous transactions from various sources, booking a capitalized software journal entry can be a difficult process. Therefore, companies need to track all the transactions closely and ensure all the invoices from external parties are generated correctly and in a timely manner. 

Steps to Book a Capitalized Software Journal Entry 

Now that we understand what a capitalized software journal entry is, let’s look at the step-by-step process to book the same:

1. Gather all the necessary data related to software development, including compensation, indirect overhead costs, direct labor costs, and software testing costs. 
2. Book the initial journal entry under the fixed assets account for any transactions related to software development. 
3. Record subsequent amortization journal entries for every accounting period until the software’s useful life is complete. 

Example of a Capitalized Software Journal Entry 

Let’s take an example to better understand how to book a capitalized software journal entry. 

Consider that ABC company is developing a software under the project name XY. The following journal entry will be recorded to capitalize the software costs incurred during the development stage:

Date	Accounts	Debit	Credit
1/1/2025	Internally developed software – Project XY	$25,000
	Payroll clearing		$25,000
	To capitalize internally developed software in 2024

Now, let’s say the useful life of the software is 10 years. The company will record the following journal entry to amortize the cost of the software over its useful life at the end of each accounting period:

Date	Accounts	Debit	Credit
1/1/2025	Amortization expense	$2,500
	Accumulated amortization		$2,500
	To record amortization of internally developed software in 2024

Differences Between Expensing and Capitalizing Software Costs

When a software is either procured or developed, all the costs will either be capitalized or expensed. Here are the key differences between the two:

Capitalizing software costs	Expensing software costs
Capitalized software costs are reflected on the balance sheet.	Expensed software costs are reflected on the income statement.
Capitalized software costs are amortized over the softwares useful life, with amortization recorded at the end of each accounting period.	If the software cost is used all within a single period, these costs are expensed and recognized immediately. .
Capitalizing software costs can help maintain higher  net income as the development costs can be matched with the revenue generated from selling the software.	Expensing software costs can decrease the net income during the period they are incurred in.

How HighRadius Can Help with Journal Entry Automation

HighRadius Record to Report Solution improves accounting by introducing automation to the forefront, dramatically increasing efficiency and accuracy. HighRadius’ no-code platform with an Excel-like interface, LiveCube, automates data extraction with  customizable templates and is capable of handling millions of records. It enables enterprises to achieve a 50% reduction in manual operations by automating processes such as data retrieval from multiple sources and grouping certain transactions to simplify journal entry posting. 

LiveCube further allows users to do a one-time set up automation for journal entry postings. HighRadius’ Journal Entry Management facilitates auto posting of entries of different formats to any ERP system or any other system of records, all the while ensuring compliance with industry standards. Journal entries can also be customized based on individual system records. I

Automated Journal Posting impacts the financial close process, allowing firms to achieve a 30% reduction in days to close. This function provides automated posting alternatives, which considerably speeds up the total closing process while maintaining accuracy. 

HighRadius offers innovative solutions that can significantly streamline the process of creating and managing journal entries. With advanced automation, real-time data synchronization, and user-friendly interfaces, HighRadius helps businesses maintain accurate and efficient financial records. By leveraging HighRadius’ technology, businesses can enhance their financial processes, ensuring accurate and timely journal entries that support overall financial health.

FAQs

1. What are capitalized software costs, and how are they recorded in accounting?

Costs including software development compensation, indirect overhead costs, direct labor costs, and software testing costs can be capitalized by businesses as per accounting standards such as GAAP and IFRS. These transactions are recorded in the balance sheet under the fixed assets account. 

2. How do you book a journal entry for capitalized software costs?

To book a journal entry for capitalized software costs, gather all business transactions occurring during the development stage and book the initial journal entry under the fixed assets account for the transactions. Record subsequent amortization journal entries for every accounting period until the software’s useful life is over.

3. What is the difference between expensing and capitalizing software costs?

Capitalizing software costs allows businesses to spread the costs associated with software development over a period of time, thereby ensuring that the net income remains high. Expensing the software costs will lead to businesses recognizing the costs associated with creating the software all at once. 

4. When should software development costs be capitalized?

Software development can be capitalized during the application development stage when the software is being developed for internal use. When the software is being developed for external use, companies can capitalize the cost after the software is technologically feasible. 

5. How does capitalization of internal-use software impact financial statements?

Capitalizing internal-use software means that the company will record the initial journal entry on the balance sheet and amortize the cost of the software over the period of its useful life. This practice ensures a high net income as the development costs are not expensed on the income statement.