I think people are missing the actual process used by Finance teams relating to this issue. I am a former CFO and spent a fair amount of time with this issue in my last role. The firm had a significant amount of software engineering expense related to its core operating system that was the backbone of the company.
The FASB accounting rules drive the capitalization of software expenses, not the tax rules. The FASB definition of GAAP (Generally Accepted Accounting Principals) for US firms is very specific and requires significant detailed tracking to comply.
As noted in one of the other posts, many companies want to capitalize as much software engineering expense as possible as that leads to higher operating income and net income. Bonuses, option grants and stock prices tend to be tied to those metrics. The argument is that building a piece of software should be treated like purchasing it off the shelf. If a firm pays $1M to implement SAP, it does not have to expense it all in one year, but rather depreciates it over its “expected life.” Since “expected life” is difficult to define for every piece of software, there are default lifetimes (similar to saying motor vehicles default to a 5 year depreciation schedule).
Tax then generally follows the GAAP accounting except when the government intervenes to try and increase capital spending. Periodically the government will allow accelerated depreciation which increases operating expenses for tax purposes only which reduces current period cash taxes. Note total taxes do not change, only when they get paid.
The Section 174 under discussion here is simply the same idea then applied to software development in an effort to juice hiring.
For the people discussing whether the IRS is effectively tracking and enforcing this - the IRS really does not matter. A companies auditors enforce it. Without all of the necessary paperwork/digital audit trail, a firm in not permitted by the auditors to capitalize the expense. The same auditors have to sign off on the tax treatment as well. Finally, with respect to maintenance, the idea is meant to be similar to the treatment for machinery ( i.e. traditional capital expenditures). When a firm puts gas in the company truck or replaces tires or fixes a windshield, they do not capitalize those expenses. The idea is the expense do not fundamentally improve the item or meaningful extend the life beyond the initial expectations. Following that line of thought, maintenance releases are not thought to extend the life of the software while significant improvements to the software do and therefore can be capitalized.
DISCLAIMER - while I was a CFO, I was not a Certified Accountant. What I have described above is what the accountants and my audit firms described to me as I worked through this issue in preparing financial statements.
"... then applied to software development in an effort to juice hiring."
How does it 'juice hiring' by removing the ability to deduct 100% of an employee's cost in one year? Who would be incentivized to hire more people when less is deductible?
You interpreted opposite of what he said. The original exception allowing for 100% of R&D expenses to be deducted in the 1st year was the juice. The issue at hand is this exception being reversed.
Apologies, I was speaking to the more general idea of allowing firms to depreciate/amortize assets faster to juice hiring. In this case, the government ended the accelerated amortization for R&D which had been juicing the hiring for many years. This happens on the “regular” capital expenditures side rather frequently with windows of accelerated depreciation to increase the purchase of machinery. It’s always for a window of time, then it expires.
This is wrong.
It's an IRS code change, not FASB. FASB doesn't oversee taxation at all. Section 174 is strictly a tax issue.
I think he stopped short of a more controversial observation (for this audience), that capitalising these expenses for tax purposes is actually closer to GAAP/what's happening in the financial statements, and the prior treatment could be viewed as a tax stimulant to encourage development.
When viewed through this lens, are growing companies trying to have their cake and eat it too - get the boost to GAAP net income for stock comp purposes etc, but defer the cash tax to future years. This perspective ties everything together for me, in terms of understanding the incentives of the players here.
I think the other piece mentioned elsewhere is the very real cash flow implications for fast growing companies, in particular those that might be smaller and with more limited access to financing (which also isn't free...). And the idea that it's a pretty blunt tool... 5 yrs for all development... every product is different and as others point out lifecycles are often much shorter.
> This perspective ties everything together for me, in terms of understanding the incentives of the players here.
Mind restating those, for those of us without the financial background who are struggling to digest these insightful comments?
For most items, there is harmony between GAAP and tax. Even though Section 174 is a tax code item, the implications of it must be properly presented on your GAAP financials. Therefore the auditors opine on it
While one of the biggest differences between GAAP and tax is the depreciation schedules for various assets, the definition of the items is generally the same.
At this point, does this really affect many people? Most businesses should be well on their way to the expenses normalizing. Outside of new businesses and old businesses splurging, would this really accomplish much?