Capitalization of software R&D choices.(Mergers, IPOs, and Venture Finance: Equities)(Professional standards)

Dressed in black from head to toe, the veteran software CFO stands on your right shoulder and says "Write it off. Expense all development costs incurred." Meanwhile your accountant is perched on your left shoulder whispering, "Capitalize your R&D. You will look more profitable, and anyway, FAS 86 says you have to."

What is a software CEO to do? Simple: expense it. Here is why. FAS 86 gives software companies a lot of leeway in how they account for expenses incurred in developing software "To Be Sold, Leased, or Otherwise Marketed." The conservative approach is to expense development costs as part of the R&D budget. Doing so sends a message to your audience (acquirers, financial analysts, CPAs and investors) that you run the financial aspects of your company prudently with no financial reporting slight of hand. When I read in the footnotes that a company expenses its software development costs, my confidence in their forecast is boosted.

Of course, you can also capitalize a portion of your development costs. How much? That is discretionary. For some reason, mildly unprofitable software companies often capitalize just enough to push their earnings into the black. And how do you account for the portion you capitalize? Some companies capitalize these costs and record them in the investing section of their cash flow statement. Great for operating income, but a good financial analyst will move it back to the operation section, or reverse it entirely.

Although not directly relevant to CEOs of small software companies, the bias of Wall Street analysts becomes important when you are looking to be acquired by a public company, and their attitude is simple: they find capitalization of development costs to be inconsistently applied and often misleading.

The traditional bias of industry veterans against capitalization of development costs may yield over time to the resurgence of SaaS business models. In a SaaS world, part of the R&D budget may be spent on a product that already has customers locked in for a period of years, which means that an intelligent allocation can be made against earnings over time. But unless you follow this model, the conservative approach will save you time and boost your credibility.

By Nat Burgess, Corum Group

Nat Burgess, executive vice president, Corum Group, 10500 NE Eighth St., Bellevue, Wash. 98004; 425/455-8281. E-mail: nburgess@corumgroup.com.

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