Accounting & Bookkeeping & Small Business Forum

[jhassman]

I am helping a small software company. They internally develop the software that is then sold to external clients. They are capitalizing a portion of their depreciation expense. I explained to them that this is circular and is capitalizing a non-cash expense but the have been advised that this is acceptable. Has anyone seen these? Can depreciation be capitalized?

Thanks for everyone's help.

[Dominic Bradish]

Interesting! I understand that research and development costs are expensed in the periods in which they are incurred. I think you are right in calling this circular, because depreciation is the process of expensing capitalized costs--how do you then capitalize what has already been capitalized? We should never pay taxes if we can do this!

[jhassman]

I checked again with CPA firm that has been doing this company's books. He cites tax reg 263a as the basis for capitalizing depreciation expense. From my quick review of 263a, I do not find this.

Anyone have insight on this?

[dp1903]

From Reg 263a:

Quote: The uniform capitalization (UNICAP) rules require the capitalization of all direct costs and certain indirect costs properly allocable to real property and tangible personal property produced by the taxpayer. For purposes of the uniform capitalization rules, to "produce" means to construct, build, install, manufacture, develop, improve, create, raise or grow.

It is reasonable to capitalize manufacturing depreciation expense when manufacturing a product, in this case, software. You have direct costs, indirect costs, and overhead which will become "Work in process" inventory. Depreciation expense for assets used in manufacturing or producing the software, i.e. computers, printers, and other such equipment should be capitalized as "work in process" which will eventually become finished goods or software for sale.

When the software is sold, the cost of finished goods [including the capitalized depreciation] is then expensed. This properly matches revenues with expense in the period of sale.

There are special rules for software which I am not familiar with, but this is applicable generally when manufacturing a product. I suggest you look at cost accounting if you aren't familiar with it. That is what you are involved with.

[jhassman]

Very interesting, I did not know this. In this case, the software platform is being "manufactured" and sold multiple times. In other words, I cannot envision a point in the near future where there will be a clear moment where the capitalized depreciation would be expensed. Not sure if this changes the scenario or not.

Thank you for your help.