In 1997 Peoplesoft, a software company, presented the following footnote information in its annual report:

The Company capitalizes software purchased from third parties if the related software product under development has reached technological feasibility or if there are alternative future uses for the purchased software, provided that capitalized amounts will be realized over a period not exceeding five years. In addition, the Company capitalizes certain internally incurred costs, consisting of salaries, related payroll taxes and benefits, and an allocation of indirect costs related to developing computer software products. Costs incurred prior to the establishment of technological feasibility are charged to product development expense. The establishment of technological feasibility and the ongoing assessment of recoverability of capitalized software development costs require considerable judgment by management with respect to certain external factors, including, but not limited to, anticipated future revenues, estimated economic life and changes in software and hardware technologies. Upon the general release of the software product to customers, capitalization ceases and such costs are amortized (using the straight-line method) on a product by product basis over the estimated life, which is generally three years. All other research and development expenditures are charged to research and development expense in the period incurred.

Capitalized software costs and accumulated amortization at December 31, 1995, 1996 and 1997 were as follows (in thousands):

1995 1996 1997 Capitalized software:
Internal development costs $7,016 $10,737 $13,232 Purchased from third parties 5,137 6,832 6,832 12,153 17,569 20,064 Accumulated amortization (4,811) (6,396) (10,358)
$7,342 $11,173 $9,706.

How much did Peoplesoft capitalize for software costs in 1996? How much was capitalized in 1997? How much did Peoplesoft record as amortization expense for software costs in 1997? What was the amortization expense in 1996? If Peoplesoft had never capitalized any software research and development outlays, how would its earnings before taxes have been affected in 1997? What would have been the effect for 1996? Why is the earnings effect of expensing versus capitalizing different in 1996 versus 1997? Microsoft does not capitalize any software costs. Why might Peoplesoft choose to capitalize some of its software costs and Microsoft expense all its costs? As a financial analyst, what questions would you raise with Peoplesoft’s CFO about the firm’s policy for amortizing software development costs?

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