Accounting for Computer Software Costs
Computer software drives the world. Businesses use software to account for transactions, communicate with colleagues and customers, and design and manufacture new products. One thing is clear: without software, we’d be lost.
Accounting for the costs associated with software acquisition, however, can be less than straightforward.
In this article, we’ll outline some things a business will need to consider when acquiring or implementing new software for its own use and how to account for those transactions.
Let’s start with the basics.
FASB (Financial Accounting Standards Board) defines an asset as something that has future economic benefits that a particular entity obtains or controls as a result of past transactions or events.
Expenses are outflows or other “using up” of assets or incurrences of liabilities (or a combination of both) from delivering or producing goods, rendering services, or carrying out other activities that constitute the entity’s ongoing major or central operations.
A good rule of thumb is that assets will benefit future periods, while expenses benefit the current period.
An entity should generally capitalize a cost if it will benefit the entity for a period of more than one year and should have a policy of when it will capitalize the cost of a product; generally, this will include a minimum acquisition cost. The organization may also capitalize the costs of putting the asset into service for the business, such as the cost of transporting the asset to the organization, taxes and installation.
Once an organization determines that they should capitalize the cost, management needs to determine how it will depreciate or amortize that cost. A business will need to reduce the net book value of an asset on its financial statements by depreciating or amortizing that cost over the asset’s estimated useful life because the business uses the asset in its operations.
Depreciation and amortization are similar concepts. Depreciation is generally associated with a reduction in costs of property and equipment and amortization is generally associated with a reduction in costs of intangible assets, such as a customer list or goodwill.
Some of the concepts we’ll discuss regarding accounting for software costs are:
- Software license
- Service contract
There are many types of software that include a perpetual license. Purchasing software with a perpetual license allows the software user/purchaser to use the software for an indefinite period of time by paying a single fee. This is the traditional model for purchasing software.
A company that purchases software with a perpetual license, assuming it satisfies an organization’s capitalization policy, will generally capitalize the cost of acquiring that software. For financial statement purposes, management will need to evaluate the estimated useful life of that software and amortize that cost, using an acceptable amortization method, over that life. A company will also generally capitalize the acquisition cost of that license for tax purposes and either amortize it over a period of 36 months or utilize a combination of Section 179 and Section 168(k) provisions to immediately expense the cost when preparing their tax return.
Benefits of the perpetual license model include definitive, fixed costs and the ability to utilize the software for an indefinite period of time.
In recent years, many software companies have shifted their revenue models from a perpetual license to a subscription-based model. Subscription-based software allows users to (usually) pay a lower fee than a perpetual license, but entitles the user to utilize the software over a finite period of time, generally one year. Should the company wish to continue utilizing the software, it must renew the license with the vendor for an additional period of time once the original agreement term expires.
The fee a company pays to a software vendor can also include services not included in the license, like upgrades or software support. Benefits to the service contract model include potentially lower up-front costs and always having the most current version of the utilized software.
Alternative names for this model include “cloud computing” or “Software as a Service (SaaS).”
When to Expense?
So, in general terms, a company would capitalize the purchase of a perpetually-licensed software and expense the costs associated with a subscription-based model that has a term of one year or less.
A contract must explicitly indicate that the customer is paying for a license to operate the software in order to be considered a software license. Otherwise, the transaction is considered a service contract and would generally require a company to expense the cost in the period the company signs the contract.
Many times, however, there are additional costs associated with the acquisition of new software. How does the software work, and will the vendor need to train employees on its functionality? Will there be a transition of data from older software to the updated version?
FASB has issued two points of guidance over recent years:
- FASB ASU 2015-05, Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40), Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement. This guidance is effective for non-public entities for annual periods beginning after December 15, 2015. This guidance is also only applicable to software that a company will use internally; it does not apply to software intended to be sold or used in research and development.
- ASU 2018-15, Intangibles - Goodwill and Other - Internal-Use Software (Subtopic 350-40), Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract. ASU 2018-15 is effective for non-public businesses for annual periods beginning after December 15, 2020, with early adoption permitted.
The critical step is to determine whether a contract is a license or service contract. If the contract is a service contract, the company will expense most costs. If the contract is a license, the company may capitalize, and subsequently amortize, the cost of the license, installation and testing, with costs such as training and maintenance expensed as incurred.
A company should expense internal and external costs incurred during the preliminary project stage. Examples of activities in this stage include the identification of performance criteria and requirements of the new software, the interview and selection of vendors who may be able to provide or assist in providing the new software, and the selection of consultants to assist in the development or installation of the software. Training and data conversion costs, except in limited circumstances, should be also be expensed.
A company should capitalize costs incurred for computer software developed or obtained for internal use during the application development stage. A company enters the application development stage when 1) the preliminary project stage is complete and 2) management has committed to funding the software project and it is probable that the project will be completed and installed.
Examples of costs that may be capitalized are:
- Fees paid to third parties for services provided to develop the software during the application stage
- Costs incurred to obtain the software
- Payroll and related costs for employees who are directly associated with the software project
- Travel costs incurred by employees in connection with developing the software
A company should expense general, administrative and overhead costs.
Management will need to closely evaluate the timing and nature of costs incurred when beginning to evaluate changes in its internally-used software. There are opportunities for favorable treatment of these costs and the company’s policies and procedures for accounting for these costs should be properly documented in an accounting manual.
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