An initial determination will have to be made as to which pronouncement applies in the circumstances. SOP requires companies to capitalize and amortize the costs associated with developing or obtaining software for internal use. Such capitalization will depend on the stage of the project and only certain specific costs are to be capitalized. In today's competitive economic environment, a key part of a company's strategic investments is its investment in technology. Companies now expend significant sums to develop, modify, test, and implement software.
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An initial determination will have to be made as to which pronouncement applies in the circumstances. SOP requires companies to capitalize and amortize the costs associated with developing or obtaining software for internal use. Such capitalization will depend on the stage of the project and only certain specific costs are to be capitalized. In today's competitive economic environment, a key part of a company's strategic investments is its investment in technology.
Companies now expend significant sums to develop, modify, test, and implement software. Furthermore, today's accounting software is not limited to the traditional general ledger and payroll packages. Indeed, software is an integral part of the manufacturing, distribution, and sales activities of companies in a wide array of industries.
While the corporate investment in software has been significant, the accounting model has been reluctant to acknowledge that these expenditures have future benefits. Thus, many have continued to question whether investments in other than tangible items should be capitalized. The reality in today's business environment is that many tangible manufacturing and distribution systems such as buildings, machinery, and equipment would not function without the software needed to operate them.
For the tangible assets to truly contribute to the company's operations i. As a result, there have been more and more frequent calls to allow the capitalization of software development costs as an asset. The point made is that the development and implementation of software is not conceptually different from the process of creating a tangible or "hard" asset, although it is riskier and the outcome more uncertain.
Additionally, it is becoming more common for companies to have well-defined development methodologies and techniques in place to help minimize this development risk and reduce the related uncertainty associated with developing software for internal use. SOP requires many companies to change their accounting for the costs of developing computer software intended to be used internally.
While conducting its deliberations on the subject, FASB was asked by some constituents to expand the scope to include accounting for all computer software costs regardless of whether the software would be marketed externally or used internally.
In particular, in March , the Management Accounting Practices Committee of the National Association of Accountants prepared an Issues Paper, Accounting for Software Used Internally, which proposed that the costs of internal-use software should be capitalized in certain situations. The [FASB] recognized that the majority of companies expense all costs of developing software for internal use, and the [FASB] was not persuaded that this current predominant practice is improper.
However, the lack of authoritative guidance has, in fact, led to an increasing diversity in accounting for internal-use software costs in the decade since the issuance of SFAS No. Which Standard? Since there are now two authoritative documents that address accounting for software development costs, the first issue to consider is whether SFAS No.
In making this determination, the critical issue for companies is whether they are developing new software with an intent to market it externally or developing new software for their own internal purposes. In substance, what this first requires is that the software be designed with unique applications to the company. Importantly, SOP notes that a substantive marketing plan would include activities such as selecting a marketing channel and identifying promotional, delivery, billing, and support activities.
Recently, some consulting firms have proposed that, once a project is completed for its client, the consulting firm would then try to market the completed software and would, if successful, share revenues with the original client. SOP observes the following: Arrangements providing for the joint development of software for mutual internal use Similarly, routine market feasibility studies are not substantive plans to market software.
As such, this type of arrangement would not constitute a marketing plan, and the provisions of SOP would be applicable. Another consideration regarding applicability of the standards is that companies often find that software development is intertwined with research and development projects. As a result, SOP requires companies to capitalize and amortize many of the costs associated with developing or obtaining software for internal use.
During the preliminary project stage, the company is in the process of evaluating alternatives regarding the software project. This can include activities such as assembling the evaluation team, evaluating vendors' proposals, and considering other reengineering efforts. During the preliminary project stage, the company has not yet decided on a software development strategy or selected a vendor.
Not surprisingly then, all such costs incurred during this stage would be expensed as incurred. Furthermore, there is no requirement to separately classify these costs in the income statement.
Application Development Stage. Once the company has made a determination as to how the software development work will be conducted, it will enter into the application development stage.
At this point, the costs incurred to develop or obtain computer software for internal use must be capitalized and accounted for as a long-lived asset. Capitalization would cease no later than the point at which the software is substantially complete--including all necessary testing--and ready for use. The costs of testing as well as installing the software are capitalizable. General and administrative costs, as well as overhead and training costs, are not capitalizable costs of internal-use software.
The capitalized cost should be amortized over the period of expected benefit in a systematic and rational manner. Obviously, it can be difficult to accurately estimate the useful life for software, but a company should make an evaluation of the expected life of the software within the context of its own operations.
In determining the expected period of benefit, companies should consider the effects of obsolescence, technology, competition, and other economic factors. Determining the Costs to Capitalize Interest.
One question companies may have is how and why should interest costs be capitalized on these projects. SFAS No. Clearly, internal-use software is such an asset.
Thus, interest would be capitalized on the internal-use software in accordance with the entity's existing interest capitalization policies. Thus, the decision of whether to capitalize interest on internal-use software depends upon its policy for capitalizing interest on tangible assets. Training, Maintenance, and Enhancements. Once the software has been placed into service, it can be difficult to determine whether subsequent changes should be capitalized or expensed.
In evaluating whether or not to capitalize the costs assigned to upgrades, only upgrades or enhancements that can be demonstrated to have additional functionality beyond the original software would be capitalized. In short, the company should ask: Does this software now do something significantly different than it did previously?
If the answer is not clearly yes, the costs should be expensed as maintenance. Importantly, AcSEC makes a distinction between increased functionality an upgrade and increased efficiency maintenance.
Modifications to software that allow the system to operate more efficiently while still performing the same functions do not result in capitalizable costs. Additionally, under SOP , the costs of training users on the use of the software would be expensed. In particular, AcSEC specifies that, when the internal- use software is no longer expected to be completed and placed in service, the asset should be treated as if abandoned or held for disposal.
As a result, it would seem the impairment issue for software placed into service is operationalized by having companies continue to make periodic assessments of the useful life of the software and make adjustments as necessary. Internal Use Software Subsequently Sold SOP specifies that the company not have a marketing plan associated with the internal use software project during its development period.
Nonetheless, it is possible the company might subsequently sell the software after it has been placed into service. The company should not recognize any profit until the aggregate proceeds from sales exceed the carrying amount of the software i. Subsequent proceeds would be recognized as earned. Other Implementation Issues Besides the accounting standards SOP establishes, there are other significant implementation issues that companies will face. These issues include determining the capitalization costs and data conversion costs.
Determining Costs to Capitalize. Companies now need to determine what payroll and payroll-related costs and external direct costs to capitalize.
To measure the payroll and payroll-related costs, it will be necessary for companies to have some measure of the time spent by its employees working on software development. Furthermore, these employees are not restricted to programmers and others directly developing the software. In most significant software development projects, the company has a team involved that would include some user representatives whose payroll costs would also be included in the capitalizable amounts.
Some companies have argued that they can avoid the need to track employee time by contracting the development of the software to an outside consulting firm. Though elegant in theory, the reality is that virtually no company is willing to give an outside consulting firm carte blanche. In almost all large software development projects, the company will have some of its own people involved in the project.
The external direct costs may seem to be an easier item to get a handle on, and, in many cases, they are. However, if the contract with the outside company is a bundled arrangement meaning that it includes several components, such as software development and installation, training, and maintenance , the company will need to unbundle the contract, because some of its elements are capitalizable while others are not.
Data Conversion Costs. Paragraph 22 of SOP discusses data conversion costs and notes that data conversion costs, "except as noted in paragraph 21, should be expensed as incurred. Thus, a reading of those two paragraphs could lead to confusion. The reality is that AcSEC is making a distinction between the writing of software to facilitate data conversion sometimes referred to as bridging software and manually converting data for use by the new system.
Clearly, it is the intent of AcSEC that manual data conversion efforts do not result in capitalizable costs. Conversely, the costs of developing bridging software are capitalizable under SOP A problem that may result with capitalizing bridging software is that the software may only be used for this specific data conversion effort i.
In that case, while the costs of developing the bridging software are capitalizable, its useful life would be of such short duration as to effectively preclude capitalization. Therefore, in determining the capitalizability of bridging software, it is extremely important that the company also assess whether there is an alternative future use to the software.
Year Issues In addition to the basic issue of software development, many companies are concerned about their existing software's ability to process information into the Year This concern has caused many companies to engage in more rapid software development and modification of existing systems than would have been contemplated otherwise. There is the additional complication that many software projects are only one component of a broader reengineering effort within the company.
These issues have been addressed in several different standards. Exhibit 2 summarizes the applicability of each of these standards. Some argued that these costs should be capitalized because the efforts extend the useful life of the software.
However, the EITF concluded that the costs incurred to make existing software Year compliant should be expensed as incurred. As can be seen, EITF Issue has substantially different accounting conclusions from SOP , thus the applicability of the documents is critical. As Exhibit 2 indicates, EITF Issue is applicable only in the specific situation where a company will be modifying existing software to make it Year compliant, i.
If the company is going to obtain or develop new software, whether motivated by Year concerns or not, SOP would apply. In Issue , the EITF notes that in today's business climate it is quite common for companies to enter into consulting contracts that will combine business process reengineering and information technology transformation.
These consulting services may include software development, software acquisition, software implementation, training, and ongoing support in addition to the business process reengineering.
Indeed, the business process reengineering may be either a component of some of the software-related activities or a separate activity. As Exhibit 2 shows, the EITF concluded that the cost of business process reengineering activities is to be expensed as incurred regardless of whether the business process reengineering is undertaken as a separate project or as part of a larger project that includes software development.
Position Paper: Capitalization And Amortization Of Software Purchases
Since SOP 98-1 was issued in early 1998, some tricky areas have emerged in its application ...
The TBR previously decided not to adopt the provisions of SOP due to limited amounts of software purchases but agreed to review when a new administrative system was purchased. In accordance with its previous recommendation, the TBR has reviewed and determined that the provisions of SOP will be followed for this and future software purchases. TBR will be implementing the software over a four year period in stages. There is no specific breakdown of software costs between the various components. Training costs will be spread over the four years with all institutions sharing costs based on the cost allocation formula that has been approved by TBR Presidents regardless of actual implementation dates. It should be noted that software licensing agreements that are not perpetual in nature will be expensed, regardless of cost. It is recommended that all costs paid to SCT for the software as well as costs paid directly to SCT for implementation services are to be capitalized.