A challenge for companies, specifically those who develop software, is the decision to record development time and costs as an asset or expense. Compounding the challenge is the question of whether the method chosen impacts the value an investor or potential buyer may place on the company. In this installment, we discuss factors to consider when selecting the appropriate method. Part two will outline how this selection might be perceived from an investor or valuation perspective.
Selecting the correct guidance
Since it often takes several years to produce the final software product, the amount of time and cost incurred related to software development is a substantial portion of a technology company’s budget. There are also the costs for enhancements, upgrades, bug fixes, and ongoing maintenance.
Some founders or executives may see recording of expenses for a substantial budget line item as unfair or inappropriate. However, the company’s intentions regarding use or sale of the software drives the decision for whether costs can be capitalized or expensed and helps determine the appropriate guidance to apply.
There are two pieces of accounting guidance that detail the attributes and factors to consider:
- ASC 350-40 “Intangibles – Goodwill and Other, Internal-Use Software”
- ASC 985 “Costs of Software to be Sold, Leased, or Marketed”
|ASC 350-40||ASC 985|
|The intention is to use the software for internal use only with no plans to market the software externally.||During development or modification, the company develops a substantive plan to sell, lease, or otherwise market the software externally.|
|Different factors and circumstances should be considered to properly determine for companies hosting their software product for customers whether they should apply ASC 350 or ASC 985.|
With the growing popularity of changing the business model to Software as a Service (SaaS), the software with a SaaS or hosting arrangement is not actually delivered to the customer, and the hosting arrangement may also qualify for the costs incurred in development to apply ASC 350. Factors to consider are whether the customers’ rights to the software include an option to take delivery of the software either during or at the end of the hosting period.
One thing for companies to note is that they can change the intention from internal use to planning to sell, lease, or market the software externally. When this happens, the company must apply the cost recovery method noted in ASC 350-40-35-7 to 35-10 before recognizing any revenue related to the sale of the software.
The importance of understanding which accounting guidance to apply (ASC 350 or ASC 985) relates to the timing of when costs may start to be capitalized. For ASC 350, there are three main stages of development noted:
- Expense: Costs associated with preliminary project stage development (concept formulation of idea and alternatives, evaluating and final selection of the alternatives, and determining technology needs) are all expensed as research and development expenses.
- Capitalize: Once a company has reached the application development stage, costs and time (internal or external) related to design of software configuration and interfaces, coding, installation of hardware, and testing with parallel processing would be capitalized as an asset.
- Expense: Post-implementation stage activities related to training and maintenance or bug fixes are expensed as research and development expenses.
For ASC 985, the timing and determination of when costs should be capitalized is more complicated and requires significant coordination and cooperation among the company’s finance and IT development departments. Expertise is required to evaluate the establishment of technological feasibility and the adequacy of a product for general release to customers.
All costs incurred to establish the technological feasibility of computer software to be sold, leased, or otherwise marketed should be charged to expense as research and development when incurred.
- The technological feasibility "is established when the entity has completed all planning, designing, coding and testing" necessary to determine that the product will meet its design specifications, including functions, features, and technical performance specifications.
- Technological feasibility is sometimes referred to having a working model (operative software with same language as the product to be sold, not a prototype, and ready for customer testing) completed or a detailed program design (blue print including specific design code and actual coding and testing of the specific program).
- Until technological feasibility of the project is reached, all costs are expensed; this could be a substantial amount for companies.
- The practice of defining technological feasibility for capitalizing software is extremely varied and difficult. Determining the exact point of a working model may be late in the development cycle of the software.
Applying the guidance correctly
Management for companies applying either accounting guidance must be able to support with appropriate documentation the actual activities of the company for the method they are applying. Detailed records are required to support cost capitalization and include (but are not limited to):
- Payroll time records
- IT coding and detail project status reports
- Time tracking for employee time spent on different development activities
Please see part two of this article for valuation and investor considerations related to recording software and development time and costs.
For more information on this topic, or to learn how Baker Tilly software and technology specialists can help, contact our team.