During buy-side Quality of Earnings, the diligence auditors want to reclassify our internal software and automation development labor from capital expenditures to operating expenses, directly lowering our adjusted EBITDA. How do we defend our capitalization policy?

Question

Tyler Smith · Accepted Answer

Diligence auditors routinely target capitalized internal labor because reclassifying development expenses from the balance sheet into the income statement reduces adjusted EBITDA on a dollar-for-dollar basis. If you capitalized $300,000 of development costs in your trailing twelve months, an auditor reclassification directly eliminates up to $2 million in enterprise value at a six-times multiple.

To defend your capitalization accounting, you must establish compliance with ASC 350-40, which governs internal-use software development. You cannot rely on broad assertions; you must present clear project governance records that isolate capital asset creation from regular maintenance.

Deliver concrete documentation showing the three stages of your technology development:
- Preliminary project stage: Show that initial research, vendor evaluation, and idea conception were expensed as operating costs rather than capitalized.
- Application development stage: Provide detailed engineering tickets, code repository commit logs, and time-tracking reports demonstrating that capitalized hours were spent strictly on designing, coding, testing, and building new operational capabilities or automation workflows.
- Post-implementation stage: Prove that ongoing maintenance, bug fixes, routine updates, and user training were properly expensed as operational overhead once the system went live.

If your internal engineers worked on both ongoing tech support and new tool creation, present a defensible allocation supported by project sprint records. Show the signed project approval documents demonstrating management commitment and commercial feasibility before development began.

When you provide clear audit trails demonstrating that your automated workflows created new, enduring operational assets rather than ongoing overhead, you force the diligence firm to preserve your capitalization treatment and maintain your adjusted EBITDA.