Financial Aspects of Technology Management

By Joseph Savidge

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.

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