Accounting for
Internal Use Software

By Paul Munter

AcSEC issues
exposure draft of SOP to fill in the gap in GAAP.

In Brief

AcSEC Takes on Software Accounting with FASB's Blessing

FASB has unofficial control over the agenda of the AICPA's accounting principles standard setter, the Accounting Standards Executive Committee (AcSEC), through its "has no objections" vote at various points along the path of a project. Sometimes FASB turns AcSEC loose on a major accounting issue, and this is one of them. The one before this was SOP 94-6 on accounting for significant risks and uncertainties. The present project addresses the absence of authoritative guidance on accounting for software to be used internally. There is much diversity in practice which prompted AcSEC to propose a uniform, workable solution. The result is a proposed SOP on Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.

The proposed SOP requires companies to capitalize and amortize many of the costs associated with developing or obtaining software for internal use. Costs incurred in connection with R&D projects or in the preliminary project stage of the software development would still be expensed as R&D. Capitalized costs should include direct external costs, payroll and payroll related costs, and appropriate interest. Subsequent enhancements would be capitalized while maintenance would be expensed.

The capitalized costs are to be amortized over the period of expected benefit and are subject to the impairment tests of SFAS No. 121. If such software is subsequently sold, the cost recovery method would be applied.

Accounting literature has not provided a clear standard on accounting for the costs of developing software a company will use internally. Not surprisingly, this lack of authoritative guidance has led to diversity in practice. Here we discuss the recent conclusions reached by the Accounting Standards Executive Committee (AcSEC) on the issue as proposed in its recently issued exposure draft, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.

Underlying Accounting Issues

The issue of the accounting for "soft" assets has received attention recently. For example, in April 1996, the Securities and Exchange Commission held a two-day conference on the accounting issues associated with intangible assets.

Computer software and the related information gathered is viewed more and more frequently by companies as a major investment in a strategic asset. Further, the development of software represents an increasingly significant portion of the economic activities of business entities. For example, for 1994, the Census Bureau estimated the U.S. software industry had sales in excess of $60 billion. Since this figure does not include the cost of software developed for internal use by companies, it understates the total cost of resources invested in software development. The fact there is no clear authoritative guidance to ensure consistent treatment for recording costs of software developed for internal use suggests our "information economy" is being run with assets only partially recognized as such in the accounting records of businesses. There is emerging anecdotal evidence that several business combinations have been motivated by the information technology of the combining companies.

Existing GAAP

As the preceding discussion indicates, there are important issues associated with the accounting for software development costs. The following is a summary of existing authoritative literature on the subject.

APB Opinion No. 17--Intangible Assets. Accounting standards for acquired intangible assets are found in APB Opinion No. 17, Intangible Assets, which addresses accounting for both identifiable and unidentifiable (goodwill) intangible assets that a company acquires. The APB concluded acquired intangible assets should be recorded at the historical cost paid for the assets. Unfortunately, the issue of determining cost or value of internally developed intangible assets is not clearly addressed in APB Opinion No. 17.

SFAS No. 2--Research and Development. SFAS No. 2, Accounting for Research and Development Costs requires that companies expense R&D costs as those costs are incurred. Unfortunately, as it relates to the development of software for internal purposes, paragraph 31 of SFAS No. 2 provides only that--

in each case the nature of the activity for which the software is being developed should be considered in relation to the guidelines...to determine whether software costs should be included or excluded [as R&D costs].

As can be seen, this left the question of whether software development costs constituted R&D or capitalizable costs largely
unanswered.

Interpretation No. 6. In an attempt to clarify the applicability of SFAS No. 2 to computer software development costs, the FASB issued Interpretation No. 6, Applicability of FASB Statement No. 2 to Computer Software. Interpretation No. 6 attempted to provide guidance on the application of SFAS No. 2 to software costs in three categories:

* Software purchased or leased,

* Software developed internally, and

* Software used in selling and administrative activities.

Importantly, Interpretation No. 6 stated that not all software costs should be included as R&D costs. To help illustrate this point, the FASB cited examples of such costs that are not R&D costs by stating--

[the FASB's intent in SFAS No. 2] was that the acquisition, development, or improvement of a process by an enterprise for use in its selling or administrative activities be excluded from the definition of research and development activities. ...Examples of the excluded costs of software are those incurred for development by an airline of a computerized reservation system or for development of a general management information system.

As a consequence, certain investments in software are clearly excluded from R&D costs. On the other hand, however, paragraph 9 of the interpretation states that costs incurred for "conceptual formulation or the translation of knowledge into a design" should be treated as R&D costs and that--

Other costs, including those incurred for programming and testing software, are research and development costs when incurred in the search or the evaluation of product or process alternatives or in the design of a preproduction model.

While providing useful guidance in certain, limited situations, Interpretation No. 6 did not readily answer the question as to whether the cost of software developed for internal purposes was capitalizable or should be expensed as R&D costs.

SFAS No. 86, Accounting for the Costs of Computer Software to be Sold, Leased or Otherwise Marketed, specifically addresses accounting for software development costs. However, SFAS No. 86 is narrow in scope; it provides accounting standards only when software is being developed with the intent the company will market the product. For such projects, SFAS No. 86 specifies that all costs incurred prior to the point where the technological feasibility of software
product has been established are R&D costs. Technological feasibility is established when--

the enterprise has completed all planning, designing, coding, and testing activities that are necessary to establish that the product can be produced to meet its design specifications.

In practice, software developers have found the technological feasibility criterion difficult to implement. Indeed, recently the software industry asked the FASB to reconsider SFAS No. 86.

Given the difficulty of implementing the provisions of SFAS No. 86, combined with the fact that SFAS No. 86 specifically stated that it "does not address the accounting and reporting of costs incurred for computer software created for internal use," the question of accounting for the cost of software developed for internal use purposes remains unanswered. It now appears an answer is on the horizon with AcSEC's proposed statement of position on the subject.

AcSEC's Proposed Statement
of Position

In its proposed statement of position (SOP), AcSEC has adopted a model that is fundamentally consistent with the notion that software is an important strategic or economic resource of the company. As such, the proposed SOP would call upon companies to capitalize and amortize many of the costs associated with developing or obtaining software for internal use. Importantly, the proposed SOP would clearly specify that all costs associated with developing software would fall under one of three documents:

* Software to be sold, leased or otherwise marketed as a separate product or as part of a product or process would be accounted for in accordance with the provisions of SFAS No. 86,

* R&D costs would be accounted for in accordance with SFAS No. 2 and FASB Interpretation No. 6, and

* Internal use software would be accounted for under the proposed SOP.

Additionally, the proposed SOP provides examples to help practitioners determine whether software should be considered for internal use and covered by the proposed SOP or whether it is part of a product or process and SFAS No. 86 is applicable. Finally, the proposed SOP clarifies when internal use computer software is and is not R&D. The accompanying logic chart presented in Exhibit 1 provides an overview of the applicability of the proposed SOP. Exhibits 2 and 3 show lists of examples provided in the SOP to help practitioners implement the proposed standard.

Characteristics of Internal Use Computer Software. According to the proposed SOP, internal use software has the following characteristics that distinguish it from software developed to be sold:

* The software is acquired, internally developed, or modified solely to meet the entity's internal needs and

* During the software's development or modification, no plan exists to market the software externally.

If both conditions are met, the proposed SOP would be applicable. If these conditions are not met, a company should apply the provisions of SFAS No. 86. Certainly, a company's past practices of selling software will be useful to help determine whether these two conditions are met. A past practice of both using and selling its own software products creates a rebuttable presumption that any subsequent software developed by the company should be accounted for in accordance with SFAS No. 86.

Stages of Computer Software Development Intended for Internal Use. For computer software intended for internal use, the SOP specifies there is typically an R&D phase prior to when capitalization of costs would begin. The proposed SOP indicates the stages of software development can be categorized as follows:

Preliminary Project Stage

Activities include--

* conceptual formulation of alternatives

* design of alternatives

* testing of alternatives

Program Instruction Stage

Activities include--

* detailed functional specifications

* coding

* testing

Implementation Stage

Activities include--

* implementation

Under this model, certain activities would constitute R&D and, according to SFAS No. 2, would be expensed as incurred.

R&D Activities of Software Developed for Internal Use. The proposed SOP specifies the following activities associated with internal use computer software should be included in R&D costs:

* Purchased or leased computer software used in R&D activities where the software does not have an alternative future use.

* All internally developed internal use computer software if 1) the software is a pilot project or 2) the software is used in a particular R&D project, regardless of whether the software has alternative future uses. According to Interpretation No. 6, however, computer software related to a company's selling and administrative activities is excluded from R&D.

* Conceptual formulation, design, and testing of possible computer software project alternative (preliminary project stage).

All such costs would be expensed as incurred and included in the total R&D expense for the period.

Capitalizable Costs for Internal Use Software. Once an entity has passed the R&D phase (i.e., the program instruction stage has begun), the proposed SOP requires that costs incurred to develop or obtain computer software for internal use be capitalized and accounted for as a long-lived asset. Capitalization would begin when the following conditions are met:

* Management, having the appropriate authority, authorizes and commits to funding a computer software project and management believes it is probable the project will be completed and used to perform the intended function and

* Conceptual formulation, design, and testing of possible software project alternatives (preliminary project stage) have been completed.

Capitalization would cease no later than the point at which the software is substantially complete--including all necessary testing--and ready for use.

Costs should include the following:

* External direct costs (that is, from transactions with third parties) of materials and services consumed in developing or obtaining internal use computer software,

* Payroll and payroll-related costs for employees who are directly associated with and who devote time to the internal use software project, and

* Interest costs capitalized in accordance with SFAS No. 34, Capitalization of Interest Cost.

General and administrative costs, as well as overhead and training costs, are not capitalizable costs of the internal use
software.

Once the internal use software is placed into service, the cost should be amortized over the period of expected benefit in a systematic and rational manner. In determining the expected period of benefit, companies should consider the effects of obsolescence, technology, competition, and other economic factors.

Enhancements and Maintenance. Once the software has been placed into service, it can be difficult to determine whether subsequent changes should be capitalized or expensed. According to the proposed SOP, costs associated with upgrades and enhancements should be capitalized while costs associated with maintenance should be expensed. An upgrade or enhancement would improve the software by either extending its life or increasing its utility or functionality.

When a company purchases software and the purchase price includes training and maintenance fees for routine maintenance work to be performed by third parties, the proposed SOP requires companies to estimate the amount of the contract price attributable to training and maintenance and exclude that amount from capitalized cost.

Impairment. Since the proposed SOP requires that internal use software be capitalized as a long-lived asset, it is not surprising that it also concludes that SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, be applied to determine whether there has been an impairment of the asset. In particular, the proposed SOP 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. Under SFAS No. 121, this would result in the entire capitalized cost being recognized as an impairment loss since the estimated selling price of an incomplete software product would typically be $0.

Internal Use Software Subsequently Sold. The proposed SOP specifies that the company not have a marketing plan associated with the internal use software project during its development. Nonetheless, it is possible the company might subsequently sell the software after it has been placed into service. According to the proposed SOP, the company would not recognize any profit until the aggregate proceeds from sales exceed the carrying amount of the software (i.e., the cost-recovery method would be applied). Subsequent proceeds would be recognized as earned.

The Comment Period

AcSEC has attempted to develop relatively comprehensive guidance on the accounting for software developed for internal purposes. The accounting for such software under the proposed SOP will represent a dramatic change for many companies. As the document is in exposure draft stage, practitioners are encouraged to take the opportunity to comment on the proposed SOP. The comment period ends April 17. *

Paul Munter, PhD, CPA, is KPMG Professor of Accounting, School of Business Administration, University of Miami.

EXHIBIT 1

DECISION TABLE FOR ACCOUNTING FOR SOFTWARE UNDER PROPOSED SOP

1.

2.

3.

4.

5.

6.

7.

8.

9.

10.

11.

12.

Status or Condition

Software is not acquired, internally developed, or modified solely to meet entity's internal needs.

During development or modification, plans to market software exist.

Software purchased or leased is to be used in R&D activities and software has no alternative use.

Software is developed as a pilot project or to be used in a specific R&D project (whether or not there is an alternative future use).

Company has not completed preliminary project stage of developing
software.

Management has not authorized and committed to funding the software project or believes project will perform intended function upon completion.

Management has authorized and committed to funding the software project and believes the project will perform intended function upon
completion

Software is substantially complete, including all necessary testing.

Software is put into service.

Apply impairment provisions of SFAS No. 121 to determine whether impairment loss exists. Use test for assets held for disposal if it is unlikely software will be completed and placed in service.

Subsequent costs extend useful life or increase utility of software.

Software is subsequently sold.

Decision

Apply SFAS No. 86

Apply SFAS No. 86

Cost is R&D

Cost is R&D

Cost is R&D

Proposed SOP not applicable

Capitalize following costs: a) external direct costs, b) payroll and payroll related costs of employees working directly on project and c) interest cost per SFAS No. 34.

Capitalization period is completed

Begin amortization of software over estimated useful life. Consider expected period of benefit, obsolescence, technology, competition, and other economic factors.

Provide for impairment loss in accordance with SFAS 121.

Capitalize cost and amortize

Apply cost recovery method

EXHIBIT 2

EXAMPLES OF SOFTWARE APPLICATIONS FOR INTERNAL USE

* A manufacturing company purchases robots and customizes the software the robots use to function. The robots are used in a manufacturing process that results in finished goods.

* A company develops software that helps it improve its cash management, which may allow the company to earn more revenue.

* A company purchases or develops software to process payroll, accounts payable, and accounts receivable.

* A company purchases software related to the installment of an online system.

* A travel agency purchases a software system to price vacation packages and obtain airfares.

* A bank develops software that allows a customer to withdraw cash, inquire about balances, make loan payments, and execute wire transfers.

* A mortgage loan servicing company develops or purchases computer software to enhance the speed of services provided to customers.

* A telecommunications company develops software to run switches necessary for various telephone services such as voice mail and call forwarding.

* A company is in the process of developing an accounts receivable system. The software specifications meet the company's internal needs and the company does not have a marketing plan before or during the development of the software. Additionally, the company has not sold any of its internal use software in the past. Two years after completion of the project, the company decides to market the product to recoup some or all of its costs.

* A broker-dealer develops a software database and charges for financial information distributed through the database.

* A company develops software to create components of music videos as a service to another company.

* A company purchases software to computerize a manual catalog and then sells the manual catalog to the public.

EXHIBIT 3

EXAMPLES OF SOFTWARE APPLICATIONS NOT FOR INTERNAL USE

* A company sells software required to operate its products, such as robots, electronic game systems, video cassette recorders, automobiles, voice-mail systems, satellites, and cash registers.

* A pharmaceutical company buys machines and writes all of the software that allows the machines to function. The pharmaceutical company then sells the machines, which help control the dispensation of medication to patients and related inventory balances, to hospitals.

* A semiconductor company develops software embedded in a microcomputer chip used in automobile electronic systems.

* A company purchases software to computerize a manual catalog and then sells the computer version and the related software to the public.

* A software company develops an operating system for sale and internal use. Though the specifications of the software meet the company's internal needs, the company had a marketing plan before the project was complete. In addition, the company has a history of selling software that it also uses internally.