What it means
When a company creates something new, it usually goes through two phases. The first is research, where it explores ideas and experiments.
The second is development, where it takes a proven concept and builds the actual product. Accounting rules treat these two phases very differently.
Research costs must be treated as expenses immediately, meaning they reduce your profits right away. However, development costs can often be capitalised.
This means you record them as a long term asset on your balance sheet and spread the cost out over several years as the product makes money. To qualify for this capitalisation, the company must meet strict tests.
You have to prove the project is technically feasible, that you intend and are able to finish it, that you have the resources to do so, and that it will probably generate future economic benefits. This distinction matters because it protects the accuracy of your financial statements.
If all development costs hit your profit and loss statement at once, a growing business might look artificially unprofitable during a heavy innovation phase. In daily practice, project managers and finance teams work closely together to track the exact hours and materials spent strictly on development.
Once the product launches, this asset is slowly reduced through a process called amortisation. This matches the expense of creating the product against the revenue it brings in over time, giving a much clearer picture of business performance.
The exact rules differ between accounting frameworks, and some of them expense most development spending, so always check which standard applies to you. Think of development costs like building a house.
Buying rough wood and testing if glue sticks is basic research that you write off. But once you draw the final blueprint and start laying bricks, those are development costs that add lasting value to your property.
In practice
Real-world examples
Example 1
TechStart Ltd spent $50,000 coding a new mobile app. Because the app has a clear commercial plan and technical viability, they capitalised these development costs as an asset on their balance sheet. After launch they will amortise it over its expected life, so profit is not hit by the full $50,000 in one year.
Example 2
BakerSoft SME invested $30,000 building custom inventory software for local bakeries. They tracked staff wages strictly during the coding phase, using timesheets, to capitalise the investment correctly. The planning work done before the design was settled was expensed, because it did not yet meet the tests.
Example 3
BioDrink Corp spent $80,000 testing a new bottling machine design. They successfully capitalised these specific development expenses to match them against future sales of the bottled drinks. When the machine entered production, the company began charging the asset to profit over its expected life.
Think of it
Think of development costs like building a house. Buying rough wood and testing if glue sticks is basic research that you write off. But once you draw the final blueprint and start laying bricks, those are development costs that add lasting value to your property.
Formula
Calculation
Total Capitalised Development Cost = Direct Labour + Direct Materials + Directly Attributable Overhead Costs
Annual Amortisation = Total Capitalised Development Cost / Useful Life
Worked example. A team spends $40,000 on programmer wages, $50,000 on cloud server fees and $10,000 on testing software during the development phase.
- Total capitalised asset = $40,000 + $50,000 + $10,000 = $100,000
- With a useful life of 5 years, annual amortisation = $100,000 / 5 = $20,000
- Carrying amount after 2 years = $100,000 - (2 x $20,000) = $60,000
Costs that fail the tests are expensed. If the same team also spent $15,000 on early research, that amount reduces profit immediately and is not added to the asset.Case study
Seen in the real world
This is a fictional, illustrative scenario. BrightView Software decided to build a cloud-based project management tool for small agencies. During the first six months, the team researched different database structures, spending $20,000. This was immediately recorded as an operating expense.
Once the team chose the final structure and began actually writing the core software code, the project entered the development phase. Over the next nine months, BrightView tracked $60,000 in developer salaries and $15,000 in specialised testing tools. Because the company had a clear business plan and enough cash to finish the software, they capitalised this total of $75,000 as an intangible asset on their balance sheet. When the software launched the following year, BrightView began amortising this asset over a useful life of five years.
This meant $15,000 was charged against profits each year, matching the creation cost directly with the subscription revenues earned from the new software tool. Without capitalisation, the whole $75,000 would have hit profit in a single year instead of $15,000. The auditors reviewed the timesheets and the project plan to confirm that the costs really belonged to the development phase, which is why BrightView kept careful records from the first day.
Watch out
Common mistakes
- Capitalising general research costs that have no guaranteed commercial outcome.
- Failing to track staff hours accurately, leading to inflated asset values.
- Forgetting to start amortization as soon as the product becomes available for use.
Questions
People also ask
What is the difference between research and development costs?
Research costs are exploratory and must be expensed immediately. Development costs happen after a concept is proven and can often be capitalised as an asset.
Why would a company want to capitalise development costs?
It spreads the expense over several years, protecting short-term profits and better matching costs with the future revenue the product generates.
Can all development costs be capitalised?
No. You must meet specific criteria, including proving technical feasibility, intent to complete, and the ability to sell the final product.