Commercial considerations for Tech Companies when capitalising development costs as intangible assets

In the first article in this series, we considered the technical accounting and audit criteria for the capitalisation of development costs for tech companies.

We then considered the tax considerations and implications, particularly with regard to R&D. In this article, we will look at the most crucial element, the commercial considerations, as well as drawing an overall conclusion.

Company decisions should always be made to support the commercial requirements of the company – rather than tax implications or how easy it will be to provide information to an auditor.

Sometimes that is easier said than done, however, capitalisation of development costs is one of the few areas where the tax implications are more limited overall and therefore the commercial drivers can really lead the decision making.

Balance Sheet position

As previously noted, under IFRS where development work meets the capitalisation criteria then the costs must be capitalised. This might deter some companies from choosing to adopt IFRS.

Under FRS 102 the accounting policy choice to capitalise the development work done on key projects has the distinct advantage of boosting a balance sheet for a company. Depending on the nature of key clients, this may be appropriate for consideration, particularly for scale up businesses that are continuously loss making.

It would be reasonable to assume that, anyone looking to invest into a business of this nature or provide funding is likely to be a sufficiently sophisticated reader of the accounts to be able to see that these represent additional costs and would therefore adjust for them when looking at company valuation or affordability of finance. However, when engaging with suppliers and more general users of the accounts a stronger balance sheet position may be beneficial.

For those looking to measure return on investment, seeing assets on the balance sheet may also help to identify the key measurable amounts.

For a third party considering a set of accounts, this optional accounting treatment does mean there is potential for a lack of comparability between companies, and it is therefore important to understand the two-accounting policy options and what they mean when considering a company.

Consistency

Where a company has cycles of development phases with costs being incurred in some years and not others, choosing to capitalise development costs as intangible assets, under FRS102, may help to create some consistency year on year rather than having significant variances in profits. This may be particularly relevant where additional contractors or staff are brought on board to support specific projects but not as permanent staff. Although, for companies with continuous development this may be less of an issue.

Internal considerations

Making the choice under FRS 102 to capitalise development costs is likely to require more work for a finance team. They will need to work with the development teams to understand their projects and the amount of time spent on development work. The relevant proportions then need to be applied to costs and salaries, adding them to the balance sheet and amortising them over a period of time.

Consideration will also need to be given to the period over which the asset will continue to generate economic benefit for amortisation rates to be considered.

There will need to be sufficient evidence around these estimates for the audit cycle. However, this should not be of significant concern or take considerable time for any well-established team. It is important, however, for costs to be tracked by projects or key areas so if a proportion of a project should become obsolete, impairment adjustments can be considered.

Moreover, for executives using management reports and considering cash flow, it is important that they sufficiently understand what the actual cash outflows are. Where costs are added to the balance sheet, to get an accurate indication of cash flows, a reader of the accounts needs to consider the EBITDA figure less the capitalised development costs. We have seen clients looking to revise the presentation of their internal reporting as this key KPI can become lost in translation. Particularly where non executive team members work with companies with differing accounting policies.

Changes to the business

In recent months we have seen an increase in the number of clients looking to revisit their capitalisation policy under FRS 102.

For those in an early development phase, reaching a key milestone in a project or sales often creates a driver to review whether capitalisation criteria have been met with a view to bringing development costs onto the balance sheet.

In contract, there are also situations where companies have been capitalising development costs for several years who are now considering whether continuing to do so is the right course of action for the business.

While this re-evaluation is usually linked to making the accounts are more relevant to the key users, it is not uncommon for changes in key executive personnel to result in a desire to review existing policies.

Under IFRS changes are of course limited as the accounting policy is more defined where recognition criteria are met.

Under FRS102, a decision not to capitalise development costs would likely be treated as a change in accounting policy and therefore require a prior year adjustment to the accounts, with corresponding consideration of changes to the tax returns.

However, movement in the life cycle of a company may mean that it is harder to demonstrate the recognition criteria are continuing to be met. This is particularly the case were some projects are in maintenance phases rather than continuing development.

Conclusions

The option to capitalise development costs under FRS 102 provides real scope for tech companies to consider the needs of users of their accounts. Along with what their key performance indicators should be and therefore what accounting treatment will be most appropriate for their business.

In practice, early-stage tech businesses often find it more straight forward to write off development costs to the P&L. Thereby choosing the simple accounting policy choice of expensing such costs and also avoiding the complexity of identifying costs to capitalise, amortise and review for impairment.

Whatever the motivation, consideration of the accounting policy options under FRS 102 should be given due care, decisions made should be documented and supporting records maintained to try and ensure consistency.