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Software capitalization refers to the process of treating software development costs as a capital asset rather than an immediate expense. If the software development meets particular criteria and conditions, you can capitalize these costs, and then amortize them over the software's useful life. Here's a brief explanation of how software capitalization works and how it impacts the income statement and balance sheet. 1. Determine eligibility: To capitalize software development costs, the project must meet specific criteria set by the IRS and follow the accounting standards like GAAP (Generally Accepted Accounting Principles). The capitalized costs usually cover the development stage only, not the preliminary project or post-implementation stages. 2. Capitalize costs: Once the project meets the criteria, you can start capitalizing the eligible software development costs. These costs may include salaries of developers, software licenses, and other necessary project expenses. You'll treat these costs as a capital asset instead of an expense and record it as such in the balance sheet. 3. Balance sheet impact: As you capitalize software development costs, you'll typically record them as an intangible asset on the balance sheet. Intangible assets include things like copyrights, patents, and software. The capitalized costs will increase the asset value and the total value of the company's assets, while not affecting the current year's expenses. 4. Amortization: Instead of expensing the software development costs upfront, you'll amortize them over the software's useful life. Amortization is the process of spreading out the cost of the asset over its useful life, similar to depreciation for tangible assets. 5. Income statement impact: Amortization is recorded as an expense in the income statement, reducing the company's net income over time. Since you're spreading the costs over several years, it could lead to a smoother and more consistent impact on the company's net income compared to expensing the entire cost in a single reporting period. In summary, software capitalization involves converting eligible software development costs into an intangible asset on the balance sheet and amortizing that amount over time through the income statement. This approach can help spread the software development costs over its useful life and can provide a more consistent financial view of the company's performance.