As with some other accounting standards, the conclusions in a recent AICPA AcSEC SOP may seem obvious. However, things are not always as they appear. In March 1998, AcSEC issued SOP 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use , which requires entities to capitalize certain internal-use software costs once certain criteria are met. The SOP applies to all nongovernment entities and must be adopted for fiscal years beginning after December 15, 1998, although earlier adoption is encouraged.
The objective here is to focus not on the requirements of SOP 98-1 but, rather, on its intent in some of the tricky areas that will require management and auditor judgment. WHEN IS SOFTWARE FOR INTERNAL USE?
For software to be considered for internal use, the SOP requires that during its development or modification no substantive plan exists or is being developed to market the software externally. If an entity has or is working on such a plan, it must account for the software costs in accordance with FASB Statement no. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed (even if it also will use the software internally).
Software costs capitalized under Statement no. 86 would almost certainly be less than costs capitalized under SOP 98-1. In fact, some have criticized this FASB statement for giving entities the ability to expense as incurred almost all costs of software to be marketed.
SOP 98-1 emphasizes substance over form. An entity should not casually say it has or is developing a marketing plan simply to follow Statement no. 86. Rather, the entity must show it has or is working on a substantive plan to market the software. Because most well-managed companies look for ways to recoup internal-use software costs, routine studies and inquiries about recouping costs are not considered substantive marketing plans under the SOP. In those instances, entities should treat the software as internal use and follow the guidance in SOP 98-1. MARKETING INTERNAL-USE SOFTWARE
During the development of internal-use software, an entity may decide to market the software to others. The SOP says the entity must apply Statement no. 86 to the existing balance of capitalized software costs and to future development costs to determine whether it can capitalize those future costs. An entity conceivably could follow SOP 98-1 in the early stages of development to capitalize more costs (and thus show less expense) and then, later in the development cycle, decide to sell the software.
Such situations should be unusual occurrences. At the start of software development projectswhich often cost millions of dollarsmanagement normally has already determined whether it should market the resulting applications. Therefore, in most cases, an entity would apply SOP 98-1 or Statement no. 86 consistently from the start of the project. LEAVING THE PRELIMINARY PROJECT STAGE
SOP 98-1 says an entity should expense costs it incurs during the preliminary project stage of software development as incurred. One typical activity an entity performs during this stage is determining whether the technology exists to develop the software. One might compare this to determining whether the technology and tools exist to build a state-of-the-art, high-tech manufacturing plant. If the technology does not exist to develop the internal-use software, a project would not leave the preliminary stage because it would be considered similar to a research and development effort. The existence of technology question is different from the issue of whether management believes it has the right talent to do the job or whether it will be able to fund the project in the event of cost overruns.
Management rarely authorizes an internal-use software project without knowing whether the technology exists to develop the software. The existence-of-technology question should, therefore, rarely prevent internal-use software projects from entering the capitalization stage.
A litmus test is whether management would go before its board of directors, owners, investors and creditors and say it is not sure whether the technology exists for a multimillion dollar internal-use software project but that it wants to proceed with the project anyway. Entities reasonably could argue that they will incur R&D costs to generate potential new revenue streams (such as discoveries of new vaccines); management would rarely approve similar arguments for uncertain internal-use software projects unless it was sure it had the technology to develop the software. SEPARATING INTERNAL COSTS
The SOP requires entities to expense internal software maintenance costs as incurred and to capitalize certain internal upgrade costs. Many of the comment letters the AICPA received on the exposure draft said entities could have difficulty dividing internal software development efforts between maintenance and upgrades.
To address this concern, SOP 98-1 gives entities an out when the upgrades are insignificant: Entities that cannot separate internal costs on a reasonably cost-effective basis between maintenance and relatively minor upgrades and enhancements should expense such costs as incurred. This idea is already imbedded in the general notion of materiality that applies to all technical literature.
Entities that embark on projects to develop internal-use software upgrades that are not relatively minor (or are material) must separate the internal costs between maintenance and upgrades. Entities should determine their own materiality thresholds. SEPARATING MULTIPLE ELEMENTS
Perhaps the situation that will require the most judgment is when entities purchase internal-use software and the package includes software training, maintenance, data conversion, reengineering or rights to unspecified future upgrades. The purchase price may cover some or all of the features the seller provides.
Entities must allocate the purchase price among the individual package elements based on objective evidence of their fair values. Even if the contract breaks out the purchase price by element, that itemization still may not be a good enough measure of fair value (because some sellers may be willing to break out the purchase price any way just as long as they get their price).
The SOP provides entities with guidance on accounting for costs of training, maintenance, data conversion and unspecified upgrades, while FASB EITF Issue no. 97-13, Accounting for Costs Incurred in Connection with a Consulting Contract or an Internal Project That Combines Business Process Reengineering and Information Technology Transformation , provides guidance on accounting for reengineering activity costs. Entities should effectively expense training, maintenance, most kinds of data conversion, unspecified upgrades and reengineering costs as they are incurred. The true software element should be capitalized in accordance with SOP 98-1. CAPITALIZABLE COSTS
Entities should capitalize certain payroll and payroll-related costs for employees who are directly associated with developing internal-use software. Eligible employees are those who help build the software, including, for example, programmers and end users who test the software. Eligible employees do not include administrative assistants, because they are not involved directly with the development effort.
SOP 98-1 says external direct costs of materials and services consumed in developing or obtaining internal-use software should be capitalized. It says further that entities should not capitalize overhead costs even if management believes the overhead is incremental to the software project. For example, entities that rent facilities to house programmers devoted to new or upgraded software projects should not capitalize costs (rent, security or building maintenance) related to those facilities as part of the software asset. USEFUL LIFE
Entities will decide useful lives for amortization purposes. The SOP cautions that internal-use software often has a relatively short useful life. Simply put, entities should not amortize Windows 95 over a 20-year life, given the frequency of upgrades to the Windows operating system.
PURCHASED SOFTWARE WITH MODIFICATIONS
SOP readers will correctly note that it does not devote much space to addressing off-the-shelf software that entities obtain from outside parties. In those instances, SOP 98-1 requires entities to capitalize the acquisition price. However, if an entity buys software and must further tweak it to conform to its specifications, it should expense or capitalize the costs of tailoring the software depending on whether the activities are preliminary project stage, application development stage or postimplementation/operation stage.
WEB SITE CONTENT DEVELOPMENT
Costs an entity incurs to develop or obtain software for its Internet Web site are subject to SOP 98-1, but costs to develop the initial or ongoing Web site content are not specifically addressed in the SOP. (Content development costs usually are greater than software costs for a Web site.) Content development costs deemed to be advertising costs should be accounted for under SOP 93-7, Reporting on Advertising Costs . Otherwise, entities will have a tough time finding authoritative support for capitalizing content development costs.
A BENEFIT TO ALL
What is obvious to AcSEC is that internal-use computer software benefits all organizations. SOP 98-1 provides a reasonable way to report those benefits as assets. Now it is up to CPAs to use good judgment when reporting those assets.
- UNDER THE REQUIREMENTS OF SOP 98-1 , Accounting for the Costs of Computer Software Developed or Obtained for Internal Use , entities should capitalize certain internal-use software costs. Internal-use software is software an entity has no substantive plans to market externally.
- AN ENTITY SHOULD NOT CASUALLY SAY it has marketing plans so it can follow the accounting rules in FASB Statement no. 86, Accounting for the Costs of Computer Software to Be Sold, Leased or Otherwise Marketed. The entity must show it has or is working on a substantive plan to market the software.
- SOP 98-1 REQUIRES ENTITIES TO EXPENSE internal-use software maintenance costs as incurred and to capitalize certain internal upgrade costs. To make this easier, the SOP gives entities an out when upgrades are insignificant. When an entity cannot separate the costs, it should expense them as incurred.
- WHEN AN ENTITY PURCHASES INTERNAL-USE software, it must allocate the purchase price among the individual elementstraining, maintenance, data conversionbased on objective evidence of their fair value. Training, maintenance and most kinds of data conversion should be expensed as incurred. The true software element should be capitalized according to SOP 98-1.
DANIEL NOLL, CPA, is a technical manager in the AICPA accounting standards division. Mr. Noll is an employee of the American Institute of CPAs and his views, as expressed in this article, do not necessarily represent the views of the AICPA. Official positions are determined through specific committee procedures, due process and deliberation.