The IAS 38 Six-Point Test
IAS 38 Intangible Assets permits capitalisation of development costs only when the entity can demonstrate all six of the following criteria. If any single criterion is not met, the costs must be expensed in the period incurred. There is no partial capitalisation; the test is binary.
All six criteria must be met simultaneously and continuously throughout the development phase. If at any point during development the company determines that it can no longer satisfy one of the criteria (for example, if funding is no longer available and criterion 5 fails), any further costs must be expensed from that point, and the previously capitalised amount must be assessed for impairment.
In practice, the sixth criterion is the most frequently contested in audits of growth-stage technology companies. Reliable measurement of expenditure attributable to the asset requires a system for tracking which employee hours, contractor invoices and direct costs are spent on the qualifying development activity versus other activities. For companies that do not operate a project management system with time-tracking, this criterion will often fail. Implementing adequate time-tracking systems is therefore a prerequisite for a robust capitalisation policy, not a consequence of it.
Research vs Development: Where Is the Line?
IAS 38 divides the creation of intangible assets into two phases: the research phase and the development phase. The distinction matters because research costs must always be expensed; development costs may be capitalised if all six criteria are met. The accounting treatment is therefore driven entirely by whether a given activity falls in the research phase or the development phase.
IAS 38 defines the research phase as activities aimed at obtaining new knowledge. Development is the application of research findings to a plan or design for producing something new or substantially improved. The practical challenge is that real-world software development does not draw a clean line between these two phases. Engineers working on a new feature are simultaneously exploring technical feasibility (research) and implementing a solution (development).
The IFRIC has stated that for software development, the transition from research to development phase occurs when technical feasibility has been established. For software specifically, this is generally interpreted as the point at which a working prototype or proof-of-concept exists that demonstrates that the technical approach is viable. Before the prototype: research phase, expense everything. After the prototype: development phase, capitalise if all six criteria are met.
"The research-to-development transition is one of the most judgement-intensive accounting decisions in a technology company. Capitalising costs incurred before technical feasibility is established is not aggressive accounting; it is an accounting error. The auditor will ask for the prototype or proof-of-concept that evidences the transition date."
The 2021 IFRIC Agenda Decision on SaaS Configuration
In April 2021, the IFRS Interpretations Committee (IFRIC) published an agenda decision on the accounting for configuration and customisation costs of SaaS arrangements. This decision has significant practical implications for companies implementing cloud-based enterprise software such as Salesforce, Workday, SAP or any other SaaS platform where the company does not control the underlying software.
The IFRIC's conclusion was clear and far-reaching: where the company does not control the underlying intangible asset (because the software runs on the supplier's infrastructure and the company has only a right to receive access over the subscription term), the costs of configuring and customising that software generally do not meet the IAS 38 criteria for capitalisation and must be expensed.
The reasoning is rooted in the control concept: to capitalise an intangible asset, you must control it. Control means you have the power to obtain future economic benefits from it and to restrict others' access to it. If the software lives on the vendor's servers and your access is dependent on maintaining the subscription, you do not control the software. The expenditure on customisation and configuration is therefore the cost of obtaining a better-configured service, not the creation of an asset that you control.
Capitalise or Expense: A Decision Framework
The following decision framework captures the key questions that must be answered before capitalising any software development cost.
How Capitalisation Affects Key Metrics
The decision to capitalise or expense software development costs has a significant impact on the income statement, balance sheet and key metrics used by investors to evaluate the business. Understanding these impacts is essential for CFOs advising boards on accounting policy choices, and for ensuring that investor presentations are transparent about the policies applied.
The reclassification of costs from operating to investing cash flow is a particular area for investor scrutiny in growth-stage technology companies. A company that capitalises a large proportion of its engineering costs will report a significantly higher operating cash flow than one that expenses the same costs. Investors should adjust for this when comparing companies with different capitalisation policies, and CFOs should proactively disclose the policy and its impact in investor presentations and data rooms.
Tax Treatment of Capitalised Software
For UK corporation tax purposes, the tax treatment of capitalised software costs follows the accounting treatment under the intangible assets regime in Part 8 of the Corporation Tax Act 2009 (CTA 2009). Where software development costs are capitalised as an intangible asset in the accounts, the amortisation charge is generally tax-deductible in the period in which it is recognised in the accounts, subject to the fixed-rate election available under CTA 2009.
The important caveat is the date of acquisition. Intangible assets created from 1 April 2002 onwards fall within the CTA 2009 regime. For most growth-stage companies, all internally developed software will fall within this regime. Under the fixed-rate election, a company can elect to deduct 4% per annum (25-year straight-line) regardless of the accounting amortisation rate, which provides cash flow certainty if the accounting policy uses a shorter amortisation period.
R&D tax credits (under either the SME scheme or RDEC, now consolidated under the new merged scheme from April 2024) interact with the capitalisation decision. Costs that are capitalised as intangible assets are generally not qualifying expenditure for R&D tax credits in the year of capitalisation; the relief is obtained via the tax deduction on amortisation. Finance teams should model the timing difference carefully, particularly for companies that rely on annual R&D credit cash receipts to fund operations.
Key Takeaways
- IAS 38 permits capitalisation of development costs only when all six criteria are met simultaneously. If any single criterion fails, the costs must be expensed immediately.
- The research phase must always be expensed. The development phase may be capitalised. The transition point is when technical feasibility is established, typically evidenced by a working prototype.
- The 2021 IFRIC Agenda Decision on SaaS configuration and customisation is one of the most commonly missed accounting rules in growth-stage companies. Costs of configuring Salesforce, Workday, SAP or any SaaS where you do not control the software are generally expensed, not capitalised.
- Capitalisation increases EBITDA and reclassifies operating cash outflow as investing cash outflow. Both effects must be disclosed transparently to investors comparing companies with different policies.
- The sixth criterion (reliable measurement) requires time-tracking systems. If your engineering team does not log hours by project, you cannot demonstrate reliable measurement and the criterion fails.
- For UK tax purposes, capitalised software costs are deductible via amortisation under CTA 2009. Consider the interaction with R&D tax credits when modelling cash flows.
