An important financial governance concern in modern enterprises is how to expense costs properly. This of course includes the costs of IT, including the costs associated with agile software development teams. There is more to this of course than just adding up expenses, these expenses need to be categorized appropriately and in some cases can have a measurable impact on your bottom line. In this blog posting we explore how to categorize agile software development costs into either capital expenses (CapEx) or operational expenses (OpEx).
Let’s begin with a few important observations:
- How you expense cost (and revenue for that matter) is driven first by accounting rules, such as Financial Accounting Standards Board (FASB) in the US, Accounting Standards for Private Enterprises (ASPE) in Canada, and International Financial Reporting Standards (IFRS) IAS 38 in general. The implication is that CapEx/OpEx decisions in part are driven by geography. At the end of this posting is an appendix summarizing these regulations.
- There are a few categories of expense, such as training and education (including coaching related expenses), which automatically fall into the operational expense category regardless of when they occur in the lifecycle.
- Where the appropriate accounting rules provide leeway, for example financial minimums for what to consider for capitalization, your corporate policy will need to guide you. A common problem in established organizations is that some of this guidance was set before agile approaches were adopted and reflect waterfall-style governance.
- How you account for expenses is orthogonal to development paradigm. It doesn’t matter what method the team follows, the actual capitalization rules remain the same. The implication is that you need to determine how to apply these rules effectively for each paradigm, and as you’ll see even by lifecycle.
- This decision, or as we’ll soon show reporting activity, is typically the purview of Finance, not IT. You really shouldn’t have to worry too much about this.
- You must engage the appropriate Finance, IT, and Audit people to ensure that everyone understands the implications of how you’re working and agrees to how you will approach accounting for expenses.
Why is This Important?
For publicly traded companies CapEx can potentially boost book value through the increase in assets (in this case a software-based solution) and increase in net income (due to lower operating expenses that year). On the other hand, OpEX is accounted for in the year that it occurs and thereby reduces net income which in turn reduces your organization’s taxes for that year.
How DAD Helps
As you can see in the appendix most of the rules for when to capitalize boil down to “start capitalizing when you know its real”, something that works well with DAD’s risk-based milestones.
As you can see in the diagram, we’ve identified two potential points where you can start capitalizing software development costs:
- Conservative: Stakeholder vision milestone. This is the point which most organizations use as their CapEx starting point. As you can see in the appendix, this milestone lines up perfectly with the regulations – you’ve made the decision to go forward with development, you’ve got a technical architecture strategy in place, you have an understanding of what you hope to produce, and so on.
- Aggressive: Project/product team start. Some organizations will choose to start capitalizing at the very beginning of a software development project because they have effectively made the decision to move forward with the effort at that point, they know what the architecture is (due to a good understanding of their existing environment and technical road map), and due to their culture it is highly unlikely that they will cancel the effort.
Of course, there are a few more issues to consider:
- You cancelled the project. If you cancel a project (or release of a product) most organizations will choose to reverse their capitalization decision for any expenses incurred with that project/release.
- You’re prototyping. Prototyping, including time spent on proof-of-concept (PoC) or spikes, is usually considered to be an operational expense because it is a learning activity. This is the case regardless of when in the lifecycle this work occurs.
- Your team follows the continuous delivery lifecycle. Teams following this lifecycle are in the Construction and Transition efforts all the time, so they’re effectively past the Stakeholder Vision milestone (the Conservative point) at all times.
- Your team follows the exploratory/lean start up lifecycle. Teams following this lifecycle are not yet at the point where they’ve made the decision to continue with development, and when they do so the typically kick into one of the other lifecycles anyway. The implication, at least from a conservative point of view, is that these expenses should be operationalized.
Needless to say, many developers, particularly agile ones, feel that time tracking is a waste. Spending 5 minutes a week is ok, and to be quite blunt should be more than sufficient, but spending fifteen minutes or more a day doing so is far too much. For CapEx/OpEx purposes you merely need to track broad categories of software development work such as Development, Prototyping, Vacation, and Training/Education. These categories will be determined by the applicable accounting rules and should be kept to a minimum.
Our advice is to keep your time tracking strategy as simple as possible, make it very clear to everyone why it’s important to capture their time accurately, and do not use the data to directly measure individuals. You may find the article Why Time Tracking Might Be the Most Valuable Activity an Agile Developer Performs to be an interesting read.
The Bottom Line
CAPEX/OPEX decision is fairly straightforward for teams that are following a Disciplined Agile Delivery (DAD) approach. The team simply needs to keep track of important milestone dates (either the Project/Team Start date or the Stakeholder Vision acceptance date) and track their time in a few broad categories as described earlier. If you do that, it’s a simple matter of running a report against your time data.
Appendix: What The Regulations Say
Disclaimer: You must read the actual regulations for yourself, what follows is just a summary and may become out of date overtime as the regulations evolve.
- Internal and external costs incurred during the preliminary project stage shall be expensed as they are incurred
- Internal and external costs incurred to develop internal-use computer software during the application development stage shall be capitalized
- Costs to develop or obtain software that allows for access to or conversion of old data by new systems shall also be capitalized
- Training costs are not internal-use software development costs and, if incurred during this stage, shall be expensed as incurred
- Data conversion costs, except as noted above, shall be expensed as incurred
- Internal and external training costs and maintenance costs during the post implementation-operation stage shall be expensed as incurred
International Financial Reporting Standards (IFRS) – IAS 38
You must be able to demonstrate ALL of following BEFORE you can START capitalizing costs:
- Technical feasibility of completing the intangible asset so that it will be available for use or sale
- Its intention to complete the intangible asset and use or sell it
- Its ability to use or sell the intangible asset
- How the intangible asset will generate probable future economic benefits. Among other things, the entity can demonstrate the existence of a market for the output of the intangible asset or the intangible asset itself or, if it is to be used internally, the usefulness of the intangible asset
Note: It is expected that FASB will recognise IAS 38 in 2016.
Canada – Accounting Standards for Private Enterprises (ASPE)
Based on ASPE, you must be able to demonstrate ALL of following BEFORE you can START capitalizing costs:
- Technical feasibility of completing the intangible asset so it will be available for use / sale
- Intention to complete the intangible asset and use / sell it
- Ability to use / sell the intangible asset
- Availability of adequate technical, financial and other resources to complete development and use / sell the intangible asset
- Ability to reliably measure the expenditure related to the intangible asset during development
- How the intangible asset will generate probable future economic benefits