- 1. SaaSCompaniesWhat CostsShould BeCapitalized?IntroductionAn
increasing number of new and established software companies are
be-coming more sassy, delivering Software as a Service (SaaS) and
re-placing the software licensing model. (The benefits to the SaaS
customerare obviousreduced capital expenditures and IT support
costs.) AlthoughSaaS companies are increasingly taking advantage of
the new multiple ele-ment revenue rules1 to accelerate
non-subscription (e.g. professional ser-vices) revenues, there
seems to be diversity in practice among the pub-lic SaaS companies
when it comes to capitalizing expenses. ArmaninoMcKenna conducted a
survey of 47 public SaaS companies to examinetheir accounting
policies for certain expenses. The results showed 70% ofthose SaaS
companies are capitalizing expenses - the two most commonexpenses
capitalized are software development expenses and sales
com-missions. To understand the diversity in capitalization
practices, we exam-ined the rules for capitalizing these and other
SaaS expenses.1FASB ASC Subtopic 605-25, Revenue Recognition
Multiple-Element Arrangements1SaaS Companies: What Costs Should Be
Capitalized?
2. SaaS Expenditures/Capitalization CostsThe table below lists
the more common SaaS expenditures and our interpretation of the
rules on capital-izing or expensing such costs. It is not meant to
be all inclusive but highlights the more common SaaSexpenditures
associated with the development and maintenance of software and/or
website applications.Portion of ExpendituresType of Software
Development Expenses Portion to ExpenseEligible for Capitalization
Salaries and employee benefits for software and1 After
technological feasibility2 or appli- website
developers/engineerscation development stage3 but before Internal
use software and related costs, such as general release2developing
or obtaining software that allows forCosts incurred to establish
access to or conversion of old data by new system technological
feasibility4NOTE: Upgrades/enhancements, (i.e., purchased software,
Fees paid to outside providers for softwareincluding those related
to a website,application, and/or website3 must be probable of
providing addi- development planning costs) and costs in-tional
functionality curred after general release4Develop website graphics
(i.e., release of bug fixes, Interest costs associated with loans
used to fund patches, inputting websitePercent attributable to
development5software development or purchase software content,
website data con-meeting capitalization criteria under a capital
lease version, registering with anAn allocated amount related to
soft- internet search engine, etc.) Indirect costs--overhead
facilities (i.e., rent, ware development after technological6
utilities, etc.) feasibility or application developmentstage but
before general release7Website-obtain and register internet
domainAll costs capitalized as other intangiblesNot
applicable8General and administrative department
costs9Training-internal and external Maintenance costs, such as 1)
keeping systems software current with revisions in hardware, 2)10
correcting errors, 3) localizing/translating soft- ware and 4)
other routine changes and additions Customer support department
costs, such as 1) services to assist customers, 2) installation11
assistance, 3) telephony support, 4) newsletters,Not applicableAs
incurred 5) onsite visits, 6) and software or data modifica- tions
One-time start-up costs, such as 1) introducing a new
product/service, 2) conducting business in a12 new territory or
with a new class of customers, or 3) commencing some new operation
Website hosting, such as monthly fees paid to13 co-location
providersPurchased software with alternative Purchased software
withfuture use (i.e., for use in developing no alternative future
use14 Purchased software software for direct resale or developing
accounted for as internal usea website) with amortization over the
software5expected period of use2Under ASC 985-20-25, Costs of
Software to Be Sold, Leased or Marketed, technological feasibility
is established when the entity has completed all planning,
designing, coding, and testingactivities that are necessary to
establish that the product can meet its designed functions,
features, and technical performance requirements.3ASC Subtopic
350-40-25, Internal Use Software, defines the application
development stage as the point at which the company completes the
initial project setup and management implicitly orexplicitly
authorizes and commits to funding and completing a computer
software project4Expense as research and development in accordance
with ASC 730-10, Research and Development-Overall5Under ASC
985-20-25, such software costs would only be capitalizable during
the application development stage and prior to general release2SaaS
Companies: What Costs Should Be Capitalized? 3. Capitalized costs
of developed software to be marketed or leased externally are
amortized on a product-by-product basis over the greater of a)
percent of current year revenues/total forecast revenues or b)
thestraight-line method over the remaining estimated useful life.
Capitalized costs related to internal usesoftware are generally
amortized on a straight-line basis. Product enhancements are
generally amortizedon a straight-line basis over the useful life of
the enhancement. Software development costs are typi-cally
categorized as research and development expenses.Incremental
ExpensesThe table below highlights incremental expenses incurred
outside of the development process.Portion of ExpendituresType of
Service ExpensesPortion to ExpenseEligible for Capitalization As
incurred is always accept-Commissions can be deferred and
amortizedable for such costs. The policyto sales expense over the
term of the relatedshould be selected based onsubscription period
as long as the commission is an analysis of the arrange-1 Internal
and external sales commissionpaid only for successful efforts and
the agree-ments and the costs incurred,ment contains a clawback
provision the company rather than on a goal ofintends to
enforce.capitalizing (or expensing) a certain amount of costs.Costs
of acquiring contracts, includ-ing 1) due diligence activities
aftercompetitive selection, 2) evaluation of2customers credit
rating and 3) prepara- Both practice and SEC staff accept
capitalizationtion and processing documentation ofof incremental
direct set-up and similar coststhe transaction incurred after a
contract is obtained, amortizingNot applicablePost-contract set-up
costs, including on a straight-line basis over the
service/contract1) setting up customer accounts, 2) term63
installation of systems and processes tosupport the acquired
contract, and 3)accumulating and converting dataAs incurred if
professionalDefer when professional services revenue cannotCosts of
delivering professional services services revenue can be4 be
separately recognized, amortizing over therelated to subscription
agreementsrecognized separately fromsame period as professional
service revenue 7subscription revenues7 Expensing all advertising
costs is an acceptable alterna- tive policy to deferralMay select a
policy to defer and expense upon5 Advertising the first time
advertising takes place (i.e., first NOTE: Accounting policy
mustshowing/ appearance of TV or magazine ad) be consistently
applied to similar kinds of advertising activities Usage based
royalty pay-Technology or software licensing/ 1. Prepayments for
time based licenses6ments expensed as reportedroyalty fee 2.
Perpetual licenses to licensor6ASC 605-10-S99, A3f, Question 4,
Revenue Recognition-SEC Materials, analogizes the capitalization
for these types of costs to the accounting treatment for loan
origination fees asoutlined in ASC 310-20-35,
Receivables-Nonrefundable Fees and Other Costs, and
warranty/maintenance contracts as outlined in ASC 605-20-25,
Revenue-Services7Under ASC 605-25-25, Multiple-Element
Arrangements, professional services cannot be separated, unless 1)
the item can be sold separately by any vendor or the customer could
resell theservices themselves; and 2) there is evidence of the fair
value of the services (i.e., price when sold separately)3SaaS
Companies: What Costs Should Be Capitalized? 4. Lack of
Capitalizing Expenses ReasoningLike all assets, deferred costs must
be evaluated for realizability. Some companies have es-sentially
eliminated the need for a realizability test by adopting a policy
of deferring costsonly to the extent of deferred revenues. This
policy is less preferable than one that adoptsa full cost deferral
model or expenses all costs as incurred. However, a policy of
deferringdirect costs to the extent of deferred revenues is
acceptable, if applied consistently. Re-gardless of the decision to
capitalize or expense, companies should appropriately disclosetheir
choice of accounting policy.Considering 70% of surveyed companies
are capitalizing costs, a question arises as to whymore companies
are not taking advantage of the capitalization rules. Weve
determined thelack of capitalizing SaaS expenses can be attributed,
in part, to the following:A short period between technological
feasibility (or application development stage)and general
releaseLower cost, more powerful development tools have created low
barriers to entry, result-ing in intense competition, accelerating
the pace of application development, shorteningthe time frame
between technological feasibility and release. This period can be
so briefthat any costs eligible for capitalization are nominal.
Additionally, the rapidly changingapplication and software
development marketplace makes it more likely that manage-ment will
terminate projects the minute the market trends have shifted. 4
SaaS Companies: What Costs Should Be Capitalized? 5. The lack in
understanding of which costs must versus may be expensedUnder the
accounting rules, certain SaaS costs must be expensed, while other
costs maybe capitalized based upon policy elections made by
management. Understanding thenuances in the accounting literature
can be unclear, confusing and complicated. For ex-ample, companies
may capitalize an allocated amount of indirect costs related to
soft-ware development, such as rent and utilities. However, the
same companies must fullyexpense general and administrative
expenses. As a result, companies may err on the sideof
conservatism, choosing to expense these costs rather than investing
time in develop-ing a SaaS capitalization policy.The impracticality
in separating capitalizable SaaS expenses from other costsAs noted
in the table prior, there are several types of SaaS expenses which
are eligiblefor capitalization. For certain companies, the time and
cost of identifying and separatingthese expenses outweighs any
benefit to be received from capitalization. For example,the percent
of loan interest cost attributable to the software development may
be capital-ized. However, separating these costs may become
impractical for certain companiesbased on the specificity required
for capitalization. Companies may also find their ac-counting
system is incapable of accurately identifying and separating costs,
thereby cre-ating another reason not to invest time in separating
these expenditures.The lack of resources to track SaaS expenditures
eligible for capitalizationConsidering recent economic conditions,
accounting and finance departments have beenreluctant to add head
count. A lean accounting and finance department could act as a
bar-rier to developing or modifying a SaaS capitalization policy,
identifying such costs in theaccounting system and tracking and
accounting for these expenditures. Moreover, othercompanies may not
be willing to invest in the resources necessary to properly
capitalizeand account for SaaS expenditures. 5 SaaS Companies: What
Costs Should Be Capitalized? 6. Best Practice RecommendationsSaaS
companies should continually evaluate the decision on when to
capitalizeversus expense software development and other incremental
costs as there areseveral short and long term implications. They
should also consult with an ac-counting professional with expertise
in SaaS revenue and expense recognition tofully understand the
alternatives, and ultimately adopt the method they believemost
closely follows the spirit of the accounting rules.A complete copy
of the public company SaaS Cost CapitalizationDatabase can be
obtained by answering five quick questions
at:http://www.surveymonkey.com/s/SaaSCostsView a sample of the
survey database on the following page.Matt Perreault is a Partner
with Armanino McKenna, a Top 40 CPA and Consult-ing firm, and is a
recognized subject matter expert in the areas of SaaS andsoftware
revenue recognition, equity accounting and public company
reportingrules. Contact Matt at [email protected] or (925)
790-2755.Ricardo D. Martinez is a Senior Manager with Armanino
McKenna and has over12 years of experience conducting audit and
advisory services predominantly inthe technology industry including
seminconductor, software, internet and on- Armanino McKenna line
educational segments. Contact Ricardo at [email protected]
or50 W. San Fernando St.(925) 790-2600 x7010Suite 600 San Jose, CA
951136www.amllp.comSaaS Companies: What Costs Should Be
Capitalized?