In today’s fast-paced world, custom software has emerged as an indispensable tool for mid-market companies needing to maintain a competitive edge, offering tailored solutions to their needs that generic off-the-shelf tools can’t match.
If you’re a CFO or CTO considering investing in custom software, it’s important to understand how it is recognized on the balance sheet. Is custom software a capital expense (CapEx) or an operating expense (OpEx)?
In this blog post, I’ll take a deep dive into accounting for custom software and help you understand the differences between CapEx and OpEx.
CapEx vs OpEx
Before we can determine whether custom software is a capital or operating expense, it’s important to understand the difference between the two.
Capital expenses are incurred to purchase or improve a long-term asset, such as property, plant, and equipment (PP&E). Capital expenses are typically large one-time expenses that are expected to provide a benefit to the company for many years. Examples of capital expenses include the purchase of a building, machinery, or software that will be used long-term.
An operating expense, on the other hand, is an expense incurred in the normal course of business activities. Operating expenses are typically recurring expenses that are required to keep the company functioning on a day-to-day basis. Examples of operating expenses include rent, utilities, salaries, and marketing expenses.
How to Determine If Custom Software is a CapEx or OpEx
Figuring out whether your custom software is a capital or operating expense might seem daunting, but it can be simplified by considering a few key factors:
Application of the Software
The first factor to consider is how your business plans to use the software. Software capitalization follows two separate sets of rules depending on if it is being developed for internal use – or being developed as a product your business intends to sell or lease. ASC Topic 350  is the set of GAAP rules that apply to internal use software, while ASC Topic 985 addresses software costs that will be sold or leased.
Because the rules around external use software are more stringent, it’s recommended to consult with a CPA to understand if CapEx or OpEx is right for your business.
Useful Life of the Software
One of the most crucial factors is the software’s expected useful life. If it’s intended for long-term use, it could be classified as a capital expense. Conversely, if it will only be used for a short period, it may be considered an operating expense.
For instance, custom software that automates accounting processes and is expected to be used long-term could be a capital expense, while software developed for a brief marketing campaign would likely be an operating expense.
Cost of the Software
Cost is another factor that companies should consider. Generally, if the cost of the software is significant, it may be considered a capital expense. The amount will depend on your business’s capitalization threshold, but usually, the threshold is lower for internal-use software. 
Customization of the Software
The level of customization required for the software is also an essential factor. If the software is tailored to meet the company’s specific needs, it may be considered a capital expense.
For instance, custom software developed to automate the manufacturing process and tailored to the company’s needs is more likely to be a capital expense. Conversely, off-the-shelf software with minor customizations is more likely to be an operating expense.
Impact on Business Operations
Lastly, companies should consider the software’s impact on their operations. If it has a significant impact, it may be considered a capital expense.
For example, custom software that enables a company to enter a new market and generate significant revenue would likely be a capital expense. However, software that provides only a minor improvement in efficiency is more likely to be an operating expense.
Whether custom software counts as a capital or operating expense depends on various factors, such as its application, useful life, cost, customization, and impact on business operations. It’s important for CFOs and CTOs to carefully consider these factors when deciding how to classify custom software expenses. This ensures accurate expense tracking and enables leaders to make informed decisions about their investments in custom software.
Undoubtedly, custom software can be a game-changer for businesses by boosting productivity, streamlining operations, and providing a competitive edge. By considering custom software as a strategic investment in the future of your business, it could be the key to unlocking the full potential of your business and achieving greater success.
A/N: Frogslayer Digital Ventures, LLC does not provide accounting-related advice or services. The content provided in this blog should not be regarded as professional accounting advice. If you seek further information, we recommend consulting with your business’s CPA.Footnotes