Questions:
Mark & Co., a software company, enters into a contract with Chris Builders, a manufacturing company, to make a software that suits the daily operations and business needs of Chris Builders. The software project’s development cost is estimated to cost $5 million. The software is expected to generate cash flows in the future for the company. The company is keen to complete the project before the year end. Chris Builders paid half of the amount in advance to Mark & Co. for building the required software. Chris Builders plans to use the software for the next few years as it will help in automating the business operations. However, the team hired to build that software lacks the necessary skills and expertise level. They are not considering to hire additional team members from outside as it will be too much costly. 

How would the cost of $5 million be treated in the accounts of Chris Builders?

What will be the impact of this transaction on the balance sheet and income statement if the $5 million software development costs are expensed compared to if they are capitalized?

Reference answers:
The cost of $5 million would be recorded as an expense in the company’s accounts. 

As per IAS 38 Intangible Assets, the development cost can be capitalized only if the following six criteria points are met: 
• Probable economic benefits
• Intention to complete the project
• Resources available to complete the project
• Ability to use or sell the item
• Technically feasible
• Expenses on the project can be identified. 

In this case, all the criteria points are met except the point “technically feasible,” since the team hired for the building and development of software has limited expertise and skill set. 

Due to this, the overall development cost cannot be capitalized as an asset. Rather, it should be recognized as an expense.

Since the transaction resulted in expense, the net income will be reduced. Moreover, the balance sheet will not be affected as the $5 million expense will not be capitalized. 

On the other hand, if the software development costs were capitalized, the assets would increase in the balance sheet and an amortization expense would be charged to the income statement.