can software be capitalized
Based on IAS 38 Intangible Assets , paragraph 4 which explains that some intangible assets may be contained in or on a physical substance such as a compact disc (in the case of computer software), legal documentation (in the case of license or patent) or film. In determining whether an asset that incorporates both intangible and tangible elements should be treated under IAS 16 Property, Plant and Equipment or as an intangible asset under IAS 38, an entity uses judgment to assess which element is more significant.
For example, computer software for a computer-controlled machine tool that cannot operate without that specific software is an integral part of the related hardware and it is treated as property, plant and equipment. The same applies to the operating system of a computer. When the software is not an integral part of the related hardware, computer software is treated as an intangible asset.
In connection with the accounting approach for the recognition of computer software costs, several questions may come up :
1. In the case of a company developing software programs for sale, should the costs incurred in developing the software be expensed, or should the costs be capitalized and amortized ?
2. If the developing software programs to be used for in-house applications only, how is the treatment ?
3. In the case of purchased software, should the cost of the software be capitalized as a tangible asset or as an intangible asset, or should it be expensed fully and immediately ?
Referring to the provision of IAS 38, the above questions can be clarified as follows :
(1) In the case of a software-developing company, the costs incurred in the development of software programs are research and development costs. Accordingly, as regulates in para. 54 of IAS 38, all expenses incurred in the research phase would be expensed. That is, all expenses incurred before technological feasibility for the product has been established should be expensed. The reporting entity would have to demonstrate both technological feasibility and a probability of its commercial success.
Technological feasibility would be established if the entity has completed a detailed program design or working model. The entity should have completed the planning, designing, coding, and testing activities and established that the product can be successfully produced.
Apart from being capable of production, the entity should demonstrate that it has the intention and ability to use or sell the program. Action taken to obtain control over the program in the form of copyrights or patents would support capitalization of these costs. At this stage the software program would be able to meet the criteria of identifiability, control, and future economic benefits, and can thus be capitalized and amortized as an intangible asset.
(2) In the case of software internally developed for in-house use – for example, a computerized payroll program developed by the reporting entity itself – the accounting approach would be different. While the program developed may have some utility to the entity itself, it would be difficult to demonstrate how the program would generate future economic benefits to the entity. Also, in the absence of any legal rights to control the program or to prevent others from using it, the recognition criteria would not be met. Further, the cost proposed to be capitalized should be recoverable. In view of the impairment test prescribed by the standard, the carrying amount of the asset may not be recoverable and would accordingly have to be adjusted. Considering the above facts, such costs may need to be expensed.
(3) In the case of purchased software, the treatment could differ and would need to be evaluated on a case-by-case basis. Software purchased for sale would be treated as inventory. However, software held for licensing or rental to others should be recognized as an intangible asset. On the other hand, cost of software purchased by an entity for its own use and which is integral to the hardware (because without that software the equipment cannot operate), would be treated as part of cost of the hardware and capitalized as property, plant, or equipment. Thus, the cost of an operating system purchased for an in-house computer, or cost of software purchased for computer-controlled machine tool, are treated as part of the related hardware.
The cost of other software programs should be treated as intangible assets (as opposed to being capitalized along with the related hardware), as they are not an integral part of the hardware. For example, the cost of payroll or inventory software (purchased) may be treated as an intangible asset provided it meets the capitalization criteria under IAS 38.
A capitalized cost is an expense that is added to the cost basis of a fixed asset on a company's balance sheet. Capitalized costs are incurred when building or financing fixed assets. Capitalized costs are not expensed in the period they were incurred, but recognized over a period of time via depreciation or amortization.
BREAKING DOWN 'Capitalized Cost'
Capitalizing costs is a method of following the matching principle of accounting. The matching principle seeks to match expenses with revenues. In other words, match the cost of an item to the period in which it is used, as opposed to when the cost was incurred. As some assets have long lives and will be generating revenue during that useful life, their costs may be amortized over a long period.
An example of where assets would and would not be capitalized can be found in the construction and operation of a warehouse. The costs associated with building the asset (including labor and financing costs) can be added to the carrying value of the fixed asset on the balance sheet. These capitalized costs will be recognized in future periods when revenues generated from the factory output are recognized.
When trying to discern what a capitalized cost is, it’s first important to make the distinction between what is defined as a cost and expense in the world of accounting. A cost on any transaction is the amount of money used in exchange for an asset. A company buying a forklift would mark such a purchase down as a cost. An expense is monetary value leaving the company, this would include something like paying the electricity bill or rent on a building.
Lets say that the warehouse in the above example was a coffee roasting facility. Some of the likely costs and expenses of building and operating a roasting facility will be paying rent on the building, customizing the interior for the specifics of the business, purchasing roasting and packing equipment, and then having that equipment installed. In addition to the machinery and hardware, the company would need to purchase green coffee (inventory) to roast, as well as pay it's laborers to roast and sell that coffee, in addition to the costs of marketing and advertising their product, sales, distribution, and so on.
Items that would show up as an expense in the company’s books would include rent on the space, utilities, pest control, wages paid to the labor operating the site once it’s operational, and anything under a certain price threshold. These are all considered expenses because the value of having use of a building, no bugs, running water, and an operational staff is being paid for, but not retained after the pay period expires. If the water bill isn’t paid, the roasting facility has no water. As for the opening party, because it's after the project was finished, it wouldn't be added to the overall cost of building the warehouse. Certain items, like a $200 laminator or a $50 chair, would be considered an expense because of its relative low cost. Each company has it’s own threshold for what they consider a cost or an expense.
The roasting facility’s packaging machine, it’s roaster, floor scales, green coffee inventory, and lunches are all items that would be considered capitalized costs on the company’s books. The monetary value isn’t leaving the company with these purchases. When the roasting company spends $130,000 on a coffee roaster and another $10,000 on green coffee beans, the value is retained in the equipment and beans as company assets.
Lunches would be included as a capitalized cost because they were a part of the project cost. The same logic is applied to the inclusion of the price of shipping and installation of equipment as costs on the company’s books. The cost of a shipping container, transportation from the farm, taxes, and freight delivery to the roasting facility could also considered part of the capitalized cost. "Attic stock" or leftover material from construction (for instance, carpet, wallpaper, and floor-boards) can also be considered a capitalized cost.
These assets would then be recorded as either current assets or long term assets on the companies balance sheet valued at their historical cost, meaning their original price.
These capitalized costs move off of the balance sheet as they are eventually ‘expensed’ either through depreciation or amortization. When the green coffee is roasted and then sold at $15,000, the original cost of the beans is marked down as an expense of $10,000 at the same time that $15,000 revenue and $5,000 profit is recorded. For a piece of equipment like a roaster, the cost can be expensed over a period of time that reflects the depreciation of value of the roaster.
The benefit of capitalizing costs is that over a period of time a company will show higher profits than it would have otherwise, this may mean that they’ll have to pay higher taxes than if they expensed a cost. When it comes to taxes though - over a longer period of time the differences in cost of taxes makes no real difference. Firms that tend to expense a cost instead of capitalizing will have somewhat lower stockholders' equity but will ultimately make no difference for a shareholder.
Capitalizing Software Development Costs
As Stanford University defines it, out of the three phases of software development -Preliminary Project Stage, Application Development Stage, and Post-Implementation/Operation Stage - only the costs from the application development stage should be capitalized. Examples of the costs a company would capitalize would include salaries of employees working on the project, their bonuses, debt insurance costs, and costs of data conversion from old software. These costs could be capitalized only as long as the project would need new testing before application.
Capitalizing costs inappropriately can lead investors to believe that a company’s profit margins are higher than they really are. Surprising or unrealistic profit margins combined with sudden drops in free cash flow (FCF), increases in capital expenditures, and a rapidly growing asset on the books be a warning signs that a company is capitalizing costs inappropriately.
Accounting CPE Courses & Books
Software capitalization involves the recognition of internally-developed software as fixed assets. Software is considered to be for internal use when it has been acquired or developed only for the internal needs of a business. Examples of situations where software is considered to be developed for internal use are:
- Accounting systems
- Cash management tracking systems
- Membership tracking systems
- Production automation systems
Further, there can be no reasonably possible plan to market the software outside of the company. A market feasibility study is not considered a reasonably possible marketing plan. However, a history of selling software that had initially been developed for internal use creates a reasonable assumption that the latest internal-use product will also be marketed for sale outside of the company.
Software Capitalization Accounting Rules
The accounting for internal-use software varies, depending upon the stage of completion of the project. The relevant accounting is:
- Stage 1: Preliminary. All costs incurred during the preliminary stage of a development project should be charged to expense as incurred. This stage is considered to include making decisions about the allocation of resources, determining performance requirements, conducting supplier demonstrations, evaluating technology, and supplier selection.
- Stage 2: Application development. Capitalize the costs incurred to develop internal-use software, which may include coding, hardware installation, and testing. Any costs related to data conversion, user training, administration, and overhead should be charged to expense as incurred. Only the following costs can be capitalized:
- Materials and services consumed in the development effort, such as third party development fees, software purchase costs, and travel costs related to development work.
- The payroll costs of those employees directly associated with software development.
- The capitalization of interest costs incurred to fund the project.
- Stage 3. Post-implementation. Charge all post-implementation costs to expense as incurred. Samples of these costs are training and maintenance costs.
Any allowable capitalization of costs should begin after the preliminary stage has been completed, management commits to funding the project, it is probable that the project will be completed, and the software will be used for its intended function.
The capitalization of costs should end when all substantial testing has been completed. If it is no longer probable that a project will be completed, stop capitalizing the costs associated with it, and conduct impairment testing on the costs already capitalized. The cost at which the asset should then be carried is the lower of its carrying amount or fair value (less costs to sell). Unless there is evidence to the contrary, the usual assumption is that uncompleted software has no fair value.
Can software licenses be capitalized?
My company is currently looking at several SaaS FP&A applications, and some vendor mentioned that while you don't have hardware to capitalize, you can do it with your licenses. Never heard about this before, anyone have any insights on this? or have done something similar? Thanks!
It depends on your SaaS agreement. If your company has a right to take possession of the software at anytime during the hosting period and your company can also run the hardware on your own hardware or on an unrelated third party's hardware, then it may able to be capitalized. If the agreement only allows you to use an interface to use the hosted software, then its likely an operating expense.
Usually, SaaS "licenses" are paid for on a short-term basis (month-to-month or quarter-to-quarter) - that's one of the attractive features of SaaS. However, if you are purchasing for, say, a year or more in advance, then yes, you would "capitalize" that purchase, but as a prepaid expense, not as software.
However, it may be that the arrangement you describe is one where you purchase a perpetual license, and then the vendor hosts the software for you. In that case then, yes, the licenses can be capitalized as software, to be written down over your standard period for software licenses (I've seen ranges of 3-5 years for software, depending on the nature of the software).
When Should Costs Be Capitalized? [Case Study]
It is not surprisingly, my post about “Capitalization and Amortization of Software Cost“ been gaining lots of reaction and questions on the ground [through email], particularly from software companies or accountants who take care of a software company. Despite that software industry is considered as a dynamic business, cost capitalization is one an old—constant debate in the accounting world. Back to the question; when should cost be capitalized? AOL is a good example to helps to showcase the judgment involved in, and potentially significant effects of, management decisions aimed at determining whether costs incurred should be capitalized or expensed.
In this post, I am going to answer the questions. With extensive life case studies come along with this post, I believe it gives a better understanding about cost capitalization concept and practices. It is not only about AOL, as I said, lots of real-life examples . Enjoy!
Back to the AOL case, the principle guiding these decisions, known generally as “the matching principle”, is simple enough. The principle ties “expense recognition” to “revenue recognition“; dictating that efforts, as represented by expenses, be matched with accomplishments (i.e., revenue), whenever it is reasonable and practicable to do so .
For example : inventory costs are not charged to cost of goods sold when the inventory is purchased. Rather, those costs are charged to expense when the inventory is sold. That way the cost of the inventory and the revenue generated by its sale are reported on the income statement in the same time period.
Similarly, a bonus paid a salesperson for completing a sale or the estimated cost of providing warranty repairs over an agreed-upon warranty period are expensed in the same time period that the related revenue is recognized. In this way, expenses incurred are matched with the recognized revenue.
Allocating Costs in a Rational and Systematic Manner
Most costs do not have such a clear association with revenue as can exist for inventory costs or a sales bonus or the estimated costs of a warranty repair. As a result, a “systematic and rational allocation” policy is used to approximate the matching principle. Thus, because a long-lived asset contributes toward the generation of revenue over several periods, the asset’s cost must be allocated over those periods.
This reporting technique seems straightforward and works reasonably well for most expenditures. It is from this systematic and rational allocation approach that we get our current method of accounting for depreciation expense. Companies record assets purchased at their cost and then allocate that cost over the future periods that benefit. Consider the following example taken from the annual report of American Greetings Corp.:
Property, plant and equipment are carried at cost. Depreciation and amortization of buildings, equipment and fixtures is computed principally by the straight-line method over the useful lives of the various assets [ America Greetings Corp., annual report, February 2000, p. 24 ]. The company records property, plant, and equipment at cost and then employs the straight-line method as a systematic and rational method for allocating that cost over the asset’s lives.
As seen with AOL, however, this systematic and rational allocation approach to matching is not always so straightforward. The method is particularly subjective when a transaction lacks a “discrete purchase event” as with property, plant, and equipment, and instead involves the incurrence of recurring expenditures over time. Management then is faced with the decision of whether to:
- capitalize those recurring expenditures
- reporting them as assets and later amortizing; or
them when incurred.
AOL decided initially to capitalize its subscriber acquisition costs. However, highlighting the subjectivity of its decision, a disagreement arose with the SEC as to the extent to which those costs actually benefited future periods. It was the SEC’s position that such future benefits were not sufficiently clear as to warrant capitalization. AOL eventually relented and wrote off the capitalized costs.
Examples of other costs for which there has been a recurring disagreement about the appropriateness of capitalization, include “software development” and “start-up costs” which I overview on the next section.
Software Development Costs
- The costs of developing new software applications are to be capitalized once technological feasibility is reached.
- Prior to that point, software development costs are expensed as incurred.
Technological feasibility is defined as that point at which all of the necessary planning, designing, coding, and testing activities have been completed to the extent needed to establish that the software application can meet its design specifications.
It is at that point that the software company has a more viable product and a higher likelihood of being able to realize its investment in the software through future revenue [ Statement of Financial Accounting Standards No. 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed (Norwalk, CT: Financial Accounting Standards Board, August 1985) ].
The following policy note provided by American Software, Inc.. It explains well how accounting for software development costs works:
Costs incurred internally to create a computer software product or to develop an enhancement to an existing product are charged to expense when incurred as research and development expense until technological feasibility for the respective product is established. Thereafter, all software development costs are capitalized and reported at the lower of unamortized cost or net realizable value. Capitalization ceases when the product or enhancement is available for general release to customers [American Software, Inc., annual report, April 2000. Information obtained from Disclosure, Inc., Compact D/SEC: Corporate Information on Public Companies Filing with the SEC (Bethesda, MD: Disclosure, Inc., December 2000)].
The definition of technological feasibility as requiring completion of the necessary planning, designing, coding, and testing to establish that the software application can meet its design specifications would seem to be rather late in the development of a new software product.
In actuality, provided a software firm has a detailed program design, or a detailed step-by-step plan for completing the software, and has available the necessary skills and hardware and software technology to avoid insurmountable development obstacles, SOFTWARE COST CAN BE CAPITALIZED ONCE THE DETAIL PROGRAM DESIGN IS COMPLETE AND HIGH-RISK DEVELOPMENT ISSUES HAVE BEEN SOLVED.
Clearly, management judgment plays a large role in determining when technological feasibility is reached and when capitalization should begin. In fact, one could reasonably argue that managements can raise or lower amounts capitalized by choice, raising or lowering earnings in the process. For example : if a firm seeks to capitalize a significant amount of software costs incurred, it should develop a detailed program design and work out design bugs early in the development process.
As a form of earnings management, some software firms may seek to minimize the amount of software development costs capitalized or even to expense all of such costs, capitalizing none. One way to achieve such an outcome in accordance with generally accepted accounting principles is to avoid the preparation of detailed program design.
Capitalization must then wait until the necessary planning, designing, coding, and testing have been completed to establish that the software application can meet its design specifications. Because the amount of software development costs incurred beyond that point is likely immaterial, it may be sufficiently late in the development process to permit the expensing of all software development costs incurred.
For example, Microsoft Corp. provides this policy note for its software development expenditures:
Research and development costs are expensed as incurred. Statement of Financial Accounting Standards (SFAS) 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed, does not materially affect the Company” [ Microsoft Corp., Form 10-K annual report to the Securities and Exchange Commission, June 2000, Exhibit 13.4, p. 6 ].
Attesting to the significant effect on earnings that a company’s software capitalization policy can have, consider again the case of American Software. If the company were to follow Microsoft’s approach and expense all of its software development costs, cumulative pretax results across the three-year period 1998 through 2000 would have been lower by $13,733,000 (sum of annual amounts capitalized minus amounts amortized). Had it followed this approach, the company’s reported cumulative pretax loss over the 1998 through 2000 time frame would have been much worse.
Many firms incur costs in developing software for their own internal use. Such costs are expensed currently until the preliminary development stage of the project is completed. After that point, essentially when a conceptual design for the software is completed, costs incurred on software are capitalized.
Consider this disclosure from the annual report of AbleAuctions.Com, Inc.:
Computer software costs incurred in the preliminary development stage are expensed as incurred. Computer software costs incurred during the application development stage are capitalized and amortized over the software’s estimated useful life [ AbleAuctions.Com, Inc. annual report, December 1999. Information obtained from Disclosure, Inc., Compact D/SEC, December 2000 ].
Accounting for start-up costs, which consist of costs related to such onetime activities as opening a new facility, introducing a new product or service, commencing activities in a new territory, pursuing a new class of customer, or initiating a new process in an existing or new facility, has changed markedly in recent years. Statement of Position 98-5, Reporting on the Costs of Start-Up Activities, now requires that all costs incurred related to start-up activities are to be expensed. Capitalization, no matter how strong an apparent link between current costs and future revenue might be, is no longer an option [ Statement of Position No. 98-5, Reporting on the Costs of Start-Up Activities (New York: American Institute of CPAs, 1998) ].
Prior to the effective date in 1999 of SOP 98-5, companies did just about anything when accounting for start-up activities.
In the United States, interest incurred on monies invested in an asset under construction is capitalized and added to the cost of the asset. Interest capitalization begins with the incurrence of construction costs and ceases when the asset is complete and ready for service. The amount of interest capitalized is actually “avoidable interest” and includes interest on monies borrowed specifically for the construction of the asset in question. In addition, interest on other borrowed funds that technically could have been repaid had available monies not been committed to the new construction project are also subject to capitalization.
Capitalized interest is netted against interest expense reported on the income statement and, depending on the nature of the ongoing construction activity, is added either to the cost of property, plant, and equipment items under construction or to discrete inventory projects, such as homes, ships, and bridges. Amounts capitalized are amortized and included in depreciation expense as property, plant, and equipment items are used in operations. Interest capitalized to inventory projects is included in cost of goods sold when the inventory item is sold. Two examples follow that are consistent with these policies.
In the first example, Ameristar Casinos, Inc., is capitalizing interest into the cost of property, plant, and equipment under construction:
Costs related to the validation of new manufacturing facilities and equipment are capitalized prior to the assets being placed in service. In addition, interest is capitalized related to the construction of such assets. Such costs and capitalized interest are amortized over the estimated useful lives of the related assets [ Ameristar Casinos, Inc., annual report, December 1999. Information obtained from Disclosure, Inc., Compact D/SEC, December 2000 ].
There are limits to the amount of interest that can be capitalized. For example : excluding limited exceptions for regulated utilities, the amount of interest capitalized cannot exceed the amount of interest incurred.
In addition, capitalization cannot continue if it were to result in the cost of an asset exceeding its net realizable value, or the amount for which an asset could be sold less the costs of sale. This net realizable value rule, or NRV rule, provides a natural limit on the amount of interest that can be capitalized and helps to prevent overcapitalization.
After periods during which significant amounts of interest costs have been capitalized, a sudden decline in construction activity can lead to sharp increases in net interest expense and a reduction in earnings.
For example : during a three-year period, interest capitalized by Domtar, Inc., declined from $20 million for the year ended December 1997 to $1 million in 1998 and $0 in 1999. At the same time, interest expense net of interest capitalized increased from $50 million in 1997 to $91 million in 1998 and $111 million in 1999 [ Domtar, Inc. annual report, December 1999. Information obtained from Disclosure, Inc., Compact D/SEC, December 2000 ].
Construction delays and cost overruns also can lead to earnings problems for companies that capitalize interest. As costs for assets under construction accumulate, cost moves ever closer to net realizable value. Once NRV is reached, future interest cannot be capitalized. Even additional construction costs will need to be expensed to prevent carrying the asset at an amount greater than NRV.
Moreover, as capitalized interest adds to the cost of assets, write-downs due to problems with assets becoming value-impaired will be greater.
For example : in 1999 U.S. Foodservice, Inc., a company with a long history of capitalizing interest on property, plant, and equipment items under construction, recorded a special charge to write down certain of these assets to net realizable value. Capitalized interest had increased the cost of these assets and added to the amount of the write-down. As noted by the company:
The Company [U.S. Foodservice, Inc.] recognized a non-cash asset impairment charge of $35.5 million related to the Company’s plan to consolidate and realign certain operating units and install new management information systems at each of the Company’s operating units. These charges consist of write-downs to net realizable value of assets of operating units that are being consolidated or realigned.
Other Capitalized Expenditures
A review of corporate annual reports turned up many other examples of expenditures that are being capitalized by various companies. A partial list of these capitalized expenditures is provided below.
- About.Com, Inc. (1999): URL costs and deferred offering costs in connection with initial public offering (IPO)
- Darling International, Inc. (1999): Environmental expenditures incurred to mitigate or prevent environmental contamination that has yet to occur and that may result from future operations
- Forcenergy, Inc. (1999): Productive and nonproductive petroleum exploration, acquisition, and development costs (full-cost method)
- Gehl Co. (1999): Costs incurred in conjunction with new indebtedness
- Hometown Auto Retailers, Inc (1999): Leasehold improvements
- InfoUSA, Inc. (1999): Direct marketing costs associated with the printing and mailing of brochures and catalogs
- J Jill Group, Inc. (1999): Creative and production costs associated with the company’s e-commerce website
- Lions Gate Entertainment Corp. (2000): Costs of producing film and television productions
- Miix Group, Inc. (1999): Policy acquisition costs representing commissions and other selling expenses
- RF Micro Devices, Inc. (2000): Costs of bringing the company’s first wafer fabrication facility to an operational state
- U.S. Aggregates, Inc.(1999): Expenditures for development, renewals, and betterments of quarries and gravel pits
Source : Disclosure, Inc., Compact D/SEC: Corporate Information on Public Companies Filing with the SEC (Bethesda, MD: Disclosure, Inc., December 2000) . Note: the year following each company name designates the specific annual report year end from which the data were compiled.
While GAAP may permit or even require capitalization of certain expenditures, it does not automatically indicate that the values assigned to any resulting assets are beyond question. The analyst has a responsibility to evaluate the realizability of such assets and make adjustments when they are warranted.
When no connection between costs and future-period revenue can be made, amounts incurred should be expensed currently. In such cases, the costs incurred do not benefit future periods and capitalization, which is tantamount to reporting current-period expenses as assets, is inappropriate. Included here would be general and administrative expenses and, in most cases, advertising and selling expenses.
Direct-Response Advertising – Direct-response advertising is an exception to the immediate expensing of selling expenses. The primary purpose of such advertising costs is to elicit sales to customers who can be shown to have responded specifically to the advertising in the past. Thus it can be demonstrated that such advertising will result in probable future economic benefits. Such costs can be capitalized when persuasive historical evidence permits formulation of a reliable estimate of the future revenue that can be obtained from incremental advertising expenditures [Statement of Position No. 93-7, Reporting on Advertising Costs (New York: American Institute of CPAs, 1993). Recall from an earlier example that the SEC determined that subscriber acquisition costs incurred by AOL did not fulfill the criteria for capitalization under guidelines for direct-response advertising.
Research and Development – Research and development costs, excluding expenditures on software development after technological feasibility is reached, also are expensed currently. One could reasonably argue that such expenditures will likely benefit future periods. Given the high-risk profile of such expenditures, however, and the uncertainty that future benefits will be derived from them, accounting standards require that such costs be expensed currently. Current expensing is a conservative approach that ensures consistency in practice across companies.
Accounting guidelines calling for the current expensing of R&D costs notwithstanding, some companies have attempted to capitalize these expenditures. For example : during the years 1988 through 1991, American Aircraft Corp. improperly capitalized R&D costs as tooling. The company, which was developing an advanced helicopter design, maintained that it had progressed past the R&D phase and that capitalization of costs incurred as production tooling was appropriate. In actuality, the costs incurred were not tooling and should have been expensed as incurred.
Patents and Licenses Closely related to the topic of accounting for R&D expenditures is the topic of accounting for the patents and licenses that can be derived from successful R&D. Capitalization is permitted of costs incurred to register or successfully defend a patent. Such expenditures are not considered to be R&D costs. Also, patents as well as licenses purchased from others can be reported as assets at the purchase price. Whether arising from the capitalization of internal costs incurred or through purchases from others, patents and licenses are amortized over the shorter of their legal or economic useful lives.
Consistent with the matching principle, costs capitalized in one period because they benefit future periods are amortized to expense in those future periods. This process of amortization, or spreading costs over several reporting periods, is used to allocate costs in a prescribed rational and systematic manner.
While here the term amortize is used generally to refer to the systematic allocation of all capitalized costs, the term frequently is used to refer to an allocation over time of the cost of intangible assets. For example, as noted by Harrah’s Entertainment, Inc.:
We amortize goodwill and other intangibles, including trademarks, on a straight-line basis over periods up to 40 years.
Depreciation, a form of amortization, is a term that typically is used to refer to an allocation of property, plant, and equipment accounts. As reported by A. Schulman, Inc.:
It is the Company’s policy to depreciate the cost of property, plant and equipment over the estimated useful lives.
Notwithstanding technical differences between the terms amortization and depreciation, they are used interchangeably here.
Depletion, also a form of amortization, refers to an allocation of the costs of natural resources—oil reserves, gravel pits, rock quarries, and the like. As disclosed by Engelhard Corp.:
Depletion of mineral deposits and mine development are provided under the units of production method.
Extended Amortization Periods
Generally accepted accounting principles provide no specific guidance as to the appropriate period of amortization for long-lived assets. As a result, judgment is needed, providing management with much discretion over reported results. By increasing an amortization period, periodic expense is lowered, raising pretax earnings.
Judgment and Amortization Periods
Evidence of the effects of professional judgment and the differences that can arise in amortization periods can be seen in the accounting policy notes that follow. All of the companies operate within a single general industry group, the manufacture of semiconductors.
From the annual report of Cypress Semiconductor Corp.:
Useful Lives in Years
Equipment 3 to 7
Buildings and leasehold improvements 7 to 10
Furniture and fixtures 5
From the annual report of Dallas Semiconductor Corp.:
Depreciation is calculated . . . over the estimated useful lives of the related assets, generally forty years for buildings, five to ten years on building improvements and two to nine years for computer hardware, software, and machinery and equipment.
From the annual report of Diodes, Inc.:
Property, plant and equipment are depreciated . . . the estimated useful lives, which range from 20 to 55 years for buildings and 1 to 10 years for machinery and equipment. Leasehold improvements are amortized using the straight-line method over 1 to 5 years.
As seen in these disclosures, all three companies depreciate property, plant, and equipment accounts over different time periods. Buildings alone are depreciated over periods as short as seven to 10 years for Cypress Semiconductor to as many as 55 years for Diodes.
As another example, Vitesse Semiconductor Corp. reports that it depreciates property
and equipment accounts over the relatively short period of three to five years, or approximately four years on average:
Vitesse began its fiscal 2000 with machinery and equipment at cost of $98,913,000. At year-end, the company reported machinery and equipment at cost of $171,761,000.56 Thus, during the year, the average cost of its machinery and equipment accounts was $135,337,000 (add the two amounts, $98,913,000 and $171,761,000, together and divide by 2). Using a four-year average depreciation period, the company would have depreciated the cost of its machinery and equipment by $33,834,000 ($135,337,000 divided by 4, assuming the straight-line method and no residual value). If the company were to extend the average useful lives of its equipment to six years, a period that is not out of line with other companies in the industry, depreciation would be reduced to $22,556,000 ($135,337,000 divided by 6), a reduction of $11,278,000, or 14% of pretax income of $81,678,000 for 2000.
Amortization periods certainly can have a significant effect on reported income. Similar differences exist for amortization periods assigned to intangibles. Consider the amortization periods primarily for intangibles provided below. The focus here is on intangibles other than goodwill. All of the companies are semiconductor manufacturers.
From the annual report of Analog Devices, Inc.:
Goodwill 5–10 years
Other Intangibles 5–10 years
From the annual report of Vitesse Semiconductor Corp.:
Goodwill and other intangibles are carried at cost less accumulated amortization, which is being provided on a straight-line basis over the economic useful lives of the respective assets, generally 5 to 15 years. As with property, plant, and equipment accounts, the amortization periods for intangibles can be diverse, ranging here from five to 15 years.
With much flexibility and discretion available to it, management may elect to employ an extended amortization period. Such a period is one that continues beyond a long-lived asset’s economic useful life. When put in place, an extended amortization period minimizes amortization expense and boosts reported earnings.