Capitalizing Your ERP System: Good in the Short-Term and the Long Run

As a CPA, I’m no stranger to the intricacies of ERP investments and how privately held manufacturing businesses book their capital and operating expenditures. It’s fairly straightforward with tangible assets, like physical equipment and the costs associated with maintaining them.

But as the world has moved increasingly towards digital environments, the standards for accounting and financial reporting have had to move with it. With more businesses incurring significant costs in complex software and cloud-based solutions, guidance from the Financial Accounting Standards Board (FASB) on how to book those expenditures has evolved.

The pivot to digital in the manufacturing industry is only going to accelerate in the coming years.

In this article, I’d like to look at what this implies for ERP solutions and the investment required for their implementation.

Can ERP systems be capitalized?

By its very nature, capitalization — recording an expenditure as an asset on a company’s balance sheet — indicates an expectation that the expenditure will have a future economic benefit for the company. Pretty clear-cut for a tangible asset, like shop floor equipment. But can that case be made for an intangible asset, like cloud-based computing or internal-use software?

According to the FASB, it can. 

Until recently, cloud-based computing costs were treated differently (from an accounting capitalization standpoint) from licensed internal-use software expenditures. In fact, FASB guidance in 2015 (issued under ASU-2015-05) explicitly stated that the costs to license and implement a cloud-based software solution were not eligible for capitalization — whereas some implementation costs associated with licensed internal-use software were.

But in 2018, the FASB updated its guidance (issued under ASU-2018-15) on intangible assets and brought accounting norms for cloud computing fees in line with those for licensed internal-use software.

The decision on whether to capitalize or expense a fee ultimately comes down to the phase of the implementation process in which it’s incurred. Costs that can be capitalized include:

• Costs incurred during the application development phase, like coding and testing
• Costs to develop or purchase software to integrate systems or convert data
• Costs to configure or customize the service (either internally or by a third party)
• Travel expenses for service providers assisting with the implementation on-site
• Payroll for employees while they’re involved in the implementation phase

Indirect costs (such as administrative fees, training costs, or any costs associated with change management) are expensed when they’re incurred.

What’s important to note here is that you can only capitalize expenditures that you incur during the application development phase. Once the project is substantially complete and the software is ready to use, any further implementation costs must be expensed.

If you can, does it mean you should?

So now that we’ve established that you can capitalize at least part of your ERP investment, let’s look at some of the benefits of doing just that.

From an accounting perspective, the benefits of capitalizing your ERP system are the same as the benefits of capitalizing any business asset. Typically, software development costs are incurred upfront, but the benefits are realized over a more extended period. On that basis alone, capitalizing your ERP system makes sense.

But let me give you a few more specific benefits you’ll realize by capitalizing your software investments.

Income smoothing — For significant expenditures, expensing the entire purchase immediately can distort the business’s net income figure for that year, affecting the company’s P&L. This is important, since the P&L usually drives a lot of decisions around capacity planning, project prioritization, and investment planning. Spreading the expense over time through capitalization can mitigate that effect.

Ratio analysis — Many companies are required by their lenders to maintain a specific ratio of assets to liabilities. Capitalizing the expenditure increases the company’s asset balance, without changing its liability balance, for improved solvency ratios.

Perceived value — Treating a software investment as an operational expense obscures its true value, and that can impact the overall perceived value of the company. Capitalization increases the company’s value by increasing its assets. Appropriate capitalization is also an indication of GAAP compliance, which is important to investors and creditors.

ERP Capitalization Is Good for Growth

If you believe (as I do) that your ERP system is a long-term asset and not just the “cost of doing business,” it’s worth taking advantage of the accounting mechanisms at your disposal to maximize the investment on your balance sheet.

As an ERP consultant, I’ve found my CPA background to be helpful when I explore the possibilities of a new or upgraded ERP solution with privately held and family-owned manufacturing companies. I’m able to dive into topics like these with insight most consultants just don’t have. This can be said for the entire team here at Syte Consulting Group, however — we all bring above-average experience and skills to the table for our clients. If you’re ready to talk about what an ERP can do for your company, schedule a free consultation with me and let’s talk!

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