Capitalising development costs

Under UK GAAP (FRS 102), companies have the option - subject to meeting specific criteria - to capitalise development costs as an intangible asset instead of expensing them immediately through the profit and loss (P&L) account.

This decision can have a material impact on their financial statements, funding conversations, tax treatment, and key performance indicators.

Note that under FRS105, development costs must be expensed through the P&L.

Option 1: Capitalising Development Costs

Pros

• Improves short-term profitability: Capitalising means the costs don’t hit your P&L immediately, which can make your business look more profitable in the near term - useful for funding rounds or bank covenants.
• Better reflects asset creation: If you're building a product (e.g. a software platform), capitalisation can more accurately reflect the cost of the investment you have made.
• Aligning revenue with costs: Costs are recognised over the life of the asset, matching future revenues with the associated costs.
• Potential to boost balance sheet: Adds to your intangible assets, which can be viewed positively by investors or lenders.

Cons

• Requires evidence and judgement: You must be able to demonstrate technical feasibility, intention to complete, ability to use/sell, and future economic benefits - this often requires good documentation and judgement.
• Increases admin burden: You'll need to track and review eligible costs carefully and amortise the asset correctly over its useful life.
• Delays tax relief: Capitalised development costs are only deductible for corporation tax when amortised, whereas P&L expenses are deductible in full when incurred (unless R&D tax relief is available).
• Audit scrutiny: Capitalisation may attract more scrutiny from auditors or investors if the criteria are not applied consistently or if the project fails commercially. Note that it may also limit the perceived value of the IP generated.

Option 2: Expensing Development Costs to the P&L

Pros:

• Simpler accounting: No need to apply capitalisation criteria or track amortisation schedules - costs are written off immediately.
• Immediate tax relief: Costs are typically deductible straight away for corporation tax purposes (again, subject to R&D relief rules).
• Conservative approach: Investors may view immediate expensing as more prudent, especially for early-stage or high-risk development projects.

Cons:

• Depresses short-term profit: Large development spends can lead to operating losses, which may impact funding rounds or external perceptions.
• Missed opportunity to recognise an asset: Your balance sheet may understate the value being created through development activity.
• Mismatch of costs and revenues: Expensing upfront may distort performance metrics if the benefit of that spend only arises in future years.

Our Recommendation

We can help you assess whether your development work meets the criteria for capitalisation, and model the impact both ways (on profit, tax and KPIs).

In general:

• Early-stage/pre-revenue: Expense to keep things simple and maximise tax relief.
• Growth-stage/scale-up: Consider capitalisation to align costs with future revenues and improve the optics of your accounts.

Notes

Both FRS 102 and FRS 105 define an ‘intangible asset’ as:

An identifiable non-monetary asset without physical substance.

An asset is identifiable when:

1. it is separable – i.e. capable of being separated or divided from the entity and sold, transferred, licensed, rented or exchanged, either individually or together with a related contract, asset or liability; or
2. it arises from contractual or other legal rights, regardless of whether those rights are transferable or separable from the entity or from other rights and obligations.

To qualify as an intangible asset, it must:

• Meet the definition of an asset: a resource controlled by the entity as a result of past events, and from which future economic benefits are expected to flow to the entity.
• Be identifiable, as explained above.

Control means the entity must be able to benefit from the intangible asset (e.g. through future cash flows) and control how it is used or disposed of.

• Separable

  The term separable is a fundamental component of the definition. It means the intangible asset is capable of being separated from the business and sold, transferred, licensed, rented or exchanged - either individually or with a related item - without disposing of the entire business.

  In practice, this means the asset must be capable of being separated from goodwill.

• Arising from Contractual or Other Legal Rights

  An intangible asset may also qualify if it arises from legal or contractual rights.

  Example: A software-as-a-service (SaaS) company obtains an exclusive licence to use a proprietary AI algorithm developed by a university under a five-year agreement. Although the algorithm cannot be sold independently of the licence, the contractual rights to use it for commercial purposes are enforceable, and the company can generate revenue from the resulting product.

  This licence arises from contractual rights, even if it’s not separable, and therefore meets the identifiability criteria for an intangible asset under FRS 102.

• Internally Generated Intangible Assets

  Internally generated intangible assets are addressed under FRS 102 in section 18.8A to 18.8K.

  • Under FRS 102, an entity can choose to capitalise development expenditure or expense it to the profit and loss account - provided the policy is applied consistently.
  • Under FRS 105, there is no option to capitalise development expenditure. All such costs must be written off to profit or loss when incurred.

• Expenditure That Can Never Be Capitalised (FRS 102, para 18.8C)

  Certain items cannot be recognised as intangible assets, including:

  • Internally generated brands, logos, publishing titles, customer lists, or similar items
  • Start-up costs (e.g. legal/secretarial costs, costs of opening a new facility or launching new products)
  • Training activities
  • Advertising and promotional activities (unless they qualify as inventory held for free or nominal distribution – see para 13.4A)
  • Costs of relocating or reorganising part or all of an entity
  • Internally generated goodwill

• Research vs Development

  • All research costs must be written off to profit or loss.
  • If there is any uncertainty as to whether a cost relates to research or development, it must be treated as research and expensed.
• FRS 102, para 18.8G gives examples of research activities:
  • Activities aimed at obtaining new knowledge
  • The search for, evaluation and selection of applications of research findings or other knowledge
  • Exploring alternatives for materials, devices, products, processes, systems or services
  • Formulating and selecting potential improvements or innovations

• When Can Development Expenditure Be Capitalised?

  Under FRS 102, development costs may be capitalised only if all the following six conditions are met:

  1. Technical feasibility of completing the asset for use or sale
  2. Intention to complete and use or sell the asset
  3. Ability to use or sell the asset
  4. Future economic benefit – either through a market for the asset or its usefulness if used internally
  5. Availability of resources (technical, financial and other) to complete and use/sell the asset
  6. Reliable measurement of the development expenditure attributable to the asset