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Financial
Aspects of Technology Management
By
Joseph Savidge
MAY 2008 - Technology-related
capital investments and operating expenses represent a significant
portion of most entities’ balance sheets and income statements.
CPAs and other financial professionals play an important role in
planning, recording, and monitoring these activities. Their involvement
may include responsibility as a CFO who oversees the technology
function or approves technology budgets within a small to mid-sized
company; an IT financial manager who reports to the chief information
officer (CIO) in a larger corporation; and a CPA in private practice
providing financial and expense-management advisory services to
clients. There are a variety of challenges that financial professionals
face when delivering these services, as well as management opportunities
that can range from improving controls over recording costs to enhancing
the ability to forecast, predict, and manage future costs.
Controlling
Technology-Related Compensation Costs
Statement
of Position (SOP) 98-1, Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use, [AICPA Accounting
Standards Executive Committee (AcSEC), March 1998] provides for
the capitalization of certain costs related to internally developed
software. The application of SOP 98-1 benefits a company by permitting
the deferral of certain compensation costs.
Not all internal
development time can be capitalized. Although time spent in managing
development resources cannot be capitalized, for example, in some
cases a developer’s time can be. By breaking down internal
development for a project into distinct phases called the system
development life cycle, the differentiation of capitalizable stages
can be seen more easily. In the preliminary project stages, developer
time spent in initiating and scoping are considered noncapitalizable,
whereas developer time spent in the application development stages,
including design, construction, testing, and implementation, are
capitalizable.
Time systems
are imperative to maintaining proper control over the time charged
to these projects. Time systems document the effort by phase and
by developer and demonstrate the proper discipline over time and
record keeping. Developers often split their time between development
and production. As stated above, time spent on development is
capitalizable. Time spent in production, however, is always expensed.
SOP 98-1 defines the areas and phases when internally developed
software time and cost can be capitalized. However, lines are
sometimes blurred between the time that developers spend on development
versus time spent on production, and SOP 98-1 is silent on this
differentiation. Distinguishing between development and production
time is difficult, because some system changes appear to have
future benefit and might influence a decision to capitalize. This
is where the financial professional should be careful.
A recommended
practice for distinguishing the capitalization of a system or
software release is as follows. Any new release can be a subject
of discussion and have potential for capitalization. Generally,
when considering whether a new release should be capitalized,
note whether the release creates new functionality. More specifically,
however, even if the release creates new functionality, when the
release is driven by the vendor, good practice is to conclude
that the release is production, and therefore the related time
and costs incurred should be expensed. When the release is driven
or prompted by the customer, the release should be considered
a project, and therefore the costs are capitalized in accordance
with SOP 98-1 and the impact on the bottom line is deferred. The
financial professional should watch for these subtle distinctions.
Managing
Technology Consulting
In cases
where internal resources to accomplish implementation or to fill
technology gaps are inadequate or unavailable, outside professionals
can be hired for specific tasks. A strong contract that includes
defined terms and conditions is essential to managing consultants.
The terms and conditions should contain a rate for straight time;
provisions for overtime and weekends; the deliverable and related
timeframes; warranties, if any, on the work performed; and treatment
of reimbursable expenses.
Using this
basic information and cost-accounting techniques, the financial
professional should construct an analysis that estimates cost
to date and expected future costs, based on the rate applied to
hours per day and time to complete. This analysis provides the
baseline overhead for comparison to current invoices, as well
as the basis for estimates to complete and assessing any future
impact. The future-impact analysis forms the basis for predicting
or estimating budgets and forecasts, as well as for reviewing
future invoices.
Controlling
Technology Capital
In addition
to the aforementioned SOP 98-1 considerations, projects often
require the purchase or leasing of technology hardware and software
(licenses) and the maintenance associated with them. Hardware
costs and installation can be capitalized, and hardware is depreciated
over its useful life. This is generally three to five years.
While software
is generally amortized over three years, exceptions exist. Sometimes
systems have to be integrated, or middleware has to be developed
so disparate older legacy systems can communicate with newly added
systems. These integration layers are developed with either internal
or external resources, and the implementation costs may be capitalized
and amortized over the course of the underlying contract for services.
GAAP requires amortizing most of these types of costs over three
years. Good practice is for the underlying system to be supported
by a contract exceeding three years, with the amortization period
corresponding to the length of the contract, which can be three
to seven years.
Maintenance
agreements associated with technology hardware or software cannot
be depreciated. Rather, such agreements are expensed over the
period of benefit, and if paid upfront they are recorded as prepaid
assets and amortized over the period of benefit, generally one
or two years, as called for in the agreement.
Ensuring
Effective Service Contracts
As noted
above, service contracts can result from a project or can be related
to a service that an organization requires. They can be complex
or simple, involve one payment or many, one or multiple years,
and one service or many different services. Not surprisingly,
some companies have thousands of different service contracts,
many for software support, subscriptions and services, technology
hardware support, and still others for core processing.
Managing
these contracts or services requires detailed analysis to track
not only the service type, but the dates they commence and end.
The overlap of years and service types makes for difficult management
because some services are based on volumes, others on time. The
detailed analysis should provide the ability to forecast or predict
what will be charged to expense in a given time period, as well
as to estimate or predict annual increases occurring at the end
of a contract period. Furthermore, the analysis should provide
enough detail to compare invoices to what was expected. This feature
presents the greatest opportunity for controlling expenses.
Often, a
financial professional is called upon to assist in constructing
contract and service-agreement features that have a wide-ranging
impact on the organization; for example, features that call for
large end-of-contract renewals, termination penalties, and other
special features calling for certain payments. This is a tremendous
benefit to operating managers, who often don’t fully understand
the financial impact of some contract provisions.
System
Conversions
Many organizations
take advantage of electronic processing to reduce costs or streamline
processing times. These changes are characterized as system conversions.
System conversions are significant to a company’s operations
and often span many cycles and years, starting with initial requirements
and specifications, then ending with testing and implementation.
Not only do conversion costs need to be recorded and tracked over
time, but the financial professional needs to ensure their completeness
and accuracy.
Once again,
SOP 98-1 and the system development life cycle need to be considered
relative to incurring these costs so costs can be properly treated
as capital or expense.
An analysis
needs to be prepared to collect the cost data, and at the very
least include summary level information on spending related to
technology hardware, software, licenses, implementation costs
(internal and external), travel expenses, and all costs that comprise
the installation of a new system or systems. To support this summary,
detailed information should be maintained at an invoice level
and should roll up to a summary for reference and discussion.
This analysis should be periodically compared to contractual terms
and conditions, forecasts, and estimates, as well as to the general
ledger for accuracy and completeness of the company’s records.
Project
Management
Projects
present many special issues for meeting the return on investment
(ROI) promised by managers, as well as control issues for financial
professionals. Many projects have phased-in approaches that require
the application of percentage-of-completion accounting. This makes
monitoring hours incurred versus total hours especially important.
While timelines, deliverables, and estimates-to-complete are essential
tools used by the project managers, without the assistance of
the financial professional preparing clear financial guidelines,
the project manager will have difficulty controlling costs.
A financial
professional should schedule critical costs to be incurred on
the project and capture those costs in an analysis so expectations
can be matched to actual events experienced on the project. This
enables a project manager to stay within project timelines and
explain major variances or departures from the plan. Project costs
can be considered either production expenses or project capital.
Once again, reference to SOP 98-1 is necessary for proper classification
of costs as capital or expense and for accurate financial reporting.
Most important
to the project manager is the accuracy of the initial scoping
and cost, because revisions to this estimate can cause unfavorable
variances in cost and delays in implementation. Tracking against
the initial cost estimate provides a basis for estimation accuracy
and the timeliness of the project. Furthermore, a detailed spending
plan highlights when technology hardware and software are to be
purchased, and where and when time should be applied based on
the project life cycle. This provides for “just in time”
equipment and enables project managers to fulfill their responsibility
to implement. Finally, the financial professional’s analysis
should answer the questions of whether the project delivered what
it promised: Did it save costs, create efficiency, or deliver
revenue? Answering these questions will address a project’s
ROI requirements.
Acquisitions
Many companies
develop models to assess acquisitions through detailed cost estimates.
No model, however, can compensate for poor data from the target.
Therefore, obtaining items from a list of requirements from the
target is critical to a complete and accurate analysis. In preparing
the model, a financial professional should ensure that it includes
estimates for all areas of operations. There are three areas of
concern in preparing a technology cost analysis when performing
a due diligence on a target:
- The ongoing
cost of technology and running the unit after it has been acquired;
- The cost
to convert systems; and
- Any contractual
termination penalties associated with the discontinued old systems.
The analysis
should include financial estimates for these three parts. First,
deciding how to outfit the target entity might include new licenses
and hardware, including wiring, switches, routers, servers, and
PCs. These amounts should be based on current invoice costs and
an estimate of what is needed in the entity.
Second is
estimating the conversion costs, which is a little more difficult
than determining the technology hardware costs. There are two
components to conversion: 1) the deconversion from the target’s
existing systems; and 2) conversion to the new systems. The deconversion
of the target’s existing systems includes all costs associated
with taking old file formats of customer or
company data and transporting them to new company systems. This
sometimes involves back-file conversions. Occasionally, companies
decide not to convert these back files, and instead decide to
maintain the old systems until the data become old enough (e.g.,
seven years) to destroy. In this case, the analysis should include
costs to maintain the old systems and costs to destroy. Otherwise,
the deconversion of old data (often characterized by a payment
to the company’s old system vendor) needs to be estimated
and added to the analysis. The cost to convert to the new systems
(characterized by payments to the company’s system vendor)
also needs to be estimated and added to the analysis. Both of
these activities result in costs that are sometimes based on contract
or estimation.
Third, and
most difficult for financial professionals, is to ascertain termination
cost. The target company often does not have copies of contracts
or has little or no knowledge of these termination clauses. Knowing
or finding all the contracts can be daunting during a short due
diligence. A request for all significant contracts and the terms
helps, but short of receiving all contracts, a review of accounts
payable will reveal recurring payments, which are a reliable clue
of underlying contracts. Those contracts should be reviewed to
identify any potential termination clauses and the related penalty
payment.
Technology
Vendor Management
Financial
professionals lend expertise to a company’s vendor management
program by performing financial due diligence on existing and
potential vendors. These vendors must demonstrate their ability
to perform their obligations, and a financial professional must
have the skills to perform that assessment.
Prior to
doing business with strategically significant companies, organizations
will engage a financial professional to perform due diligence.
That process will include a review of the business terms and of
the viability of the vendor. The financial professional’s
review of the audited financial reports, credit reports, and tax
returns will reveal the soundness of the company and its ability
to deliver its terms.
Joseph
Savidge, CPA, is a senior vice president with Webster Bank
in Bristol, Conn., with responsibility for technology and back-office
operations.
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