Daniel Bringhurst, CPA, is an Audit Senior Manager at Larson & Company. He specializes in auditing captive insurance, insurance, and middle market entities. Daniel is our subject matter expert in due diligence and mergers and acquisitions. 

 

With the increasing use of cloud-based software, the accounting for such arrangements has never been more relevant. The guidance for software developed or obtained for internal-use is prescribed by ASC 350-40, Intangibles – Goodwill and Other. Below we will outline some common questions faced when accounting for internal-use software and the accounting guidance that can help answer these questions.

Do I have internal-use software?

Based on the guidance in ASC 350-40-15, internal-use software must have the following characteristics:

  1. The software is acquired, internally developed, or modified solely to meet the entity’s internal needs and
  2. During the software’s development or modification, no substantive plan exists or is being developed to market the software externally

Additionally, if the internal-use software is obtained via a hosting arrangement, the following criteria must be met for the guidance in ASC-350-40-15-4A to be applied.

  1. The customer has the contractual right to take possession of the software at any time during the hosting period without significant penalty and
  2. It is feasible for the customer to either run the software on its own hardware or contract with another party unrelated to the vendor to host the software.

If these two criteria are not met for internal-use software obtained via a hosting arrangement, these are considered to be service contracts and do not constitute a purchase of software.

What costs can I capitalize?

When developing internal-use software, costs incurred are generally split into three categories, 1) preliminary project stage, 2) application development stage, and 3) postimplementation-operation stage. Based on the guidance in ASC 350-40-25, only those costs incurred in the application development stage are to be capitalized, costs incurred during the other two stages are to be expensed. Below are some examples of costs incurred that can be expensed in accordance with ASC 350-40-30.

  1. External direct costs of materials and services consumed in developing or obtaining internal-use computer software. Examples of those costs include but are not limited to the following:
    • Fees paid to third parties for services provided to develop the software during the application development stage
    • Costs incurred to obtain computer software from third parties
    • Travel expenses incurred by employees in their duties directly associated with developing software.
  2. Payroll and payroll-related costs (for example, costs of employee benefits) for employees who are directly associated with and who devote time to the internal-use computer software project, to the extent of the time spent directly on the project. Examples of employee activities include but are not limited to coding and testing during the application development stage.
  3. Interest costs incurred while developing internal-use computer software.

Future costs incurred for upgrades and enhancements of the internal-use software are expensed or capitalized following the same guidelines as those defined above.

Some implementation cost for service contracts (those that do not meet both criteria in ASC 350-40-15-4A above) can still be capitalized similarly to the methods noted above. However, they will be treated as prepaid expenses for a service contract and not capitalized assets.

How do I account for the capitalized costs?

For those costs which are determined to be capitalized, these costs can be amortized on a straight-line basis over a time period that is representative of the software’s useful life. The following factors from ASC 350-40-35 should be considered when determining the appropriate useful life.

  1. Obsolescence
  2. Technology
  3. Competition
  4. Other economic factors
  5. Rapid changes that may be occurring in the development of software products, software operating systems, or computer hardware and whether management intends to replace any technologically inferior software or hardware.

How do I report these costs in my financial statements?

The presentation requirements are dependent on whether or not the costs meet the requirements to be accounted for as internal-use software under ASC 350. The differences in presentation may have impacts on key measurements such as EBITDA and cash from operating activities.

Financial statement Internal-Use Software Service Contracts
Balance sheet Fixed or intangible asset Prepaid or other asset
Income statement Depreciation/amortization Operating expense
Statement of cash flows Investing activities Operating activities

 

More questions?

Larson & Company has extensive experience helping companies of all sizes with the accounting for their software costs and is ready to assist you with any further questions. Please feel free to reach out to Daniel Bringhurst at dbringhurst@larsco.com for more information.