As it has been described in my previous post, IAS 38 permits recognition of internally created intangible assets to the extent the expenditures can be analogized to the development phase of a research and development program, including cost incurred in computer software developments for internal use.
“Are all of the computer software costs allowed to be capitalized—and recognized as internally generated intangible? And, what are the recognition principles?” You may ask.
As long as they meets the recognition criteria, the cost is determined using the same principles as for an acquired tangible asset. Thus, cost comprises all costs directly attributable to creating, producing, and preparing the asset for its intended use (read my previous post). The recognition of computer software costs poses several questions:
1. In the case of a company developing software programs for sale, should the costs incurred in developing the software be expensed, or should the costs be capitalized and amortized?
2. Is the treatment for developing software programs different if the program is to be used for in-house applications only?
3. In the case of purchased software, should the cost of the software be capitalized as a tangible asset or as an intangible asset, or should it be expensed fully and immediately?
In view of IAS 38’s provisions the position can be clarified as follows:
In the case of a software-developing company, the costs incurred in the development of software programs are research and development costs. Accordingly, all expenses incurred in the research phase would be expensed. That is, all expenses incurred before technological feasibility for the product has been established should be expensed.
The reporting entity would have to demonstrate both technological feasibility and a probability of its commercial success. Technological feasibility would be established if the entity has completed a detailed program design or working model. The entity should have completed the planning, designing, coding, and testing activities and established that the product can be successfully produced.
Apart from being capable of production, the entity should demonstrate that it has the intention and ability to use or sell the program. Action taken to obtain control over the program in the form of copyrights or patents would support capitalization of these costs. At this stage the software program would be able to meet the criteria of identifiability, control, and future economic benefits, and can thus be capitalized and amortized as an intangible asset.
In the case of software internally developed for in-house use—for example, a computerized payroll program developed by the reporting entity itself—the accounting approach would be different.
While the program developed may have some utility to the entity itself, it would be difficult to demonstrate how the program would generate future economic benefits to the enterprise. Also, in the absence of any legal rights to control the program or to prevent others from using it, the recognition criteria would not be met.
Further, the cost proposed to be capitalized should be recoverable. In view of the impairment test prescribed by the standard, the carrying amount of the asset may not be recoverable and would accordingly have to be adjusted. Considering the above facts, such costs may need to be expensed.
In the case of purchased software, the treatment could differ and would need to be evaluated on a case-by-case basis. Software purchased for sale would be treated as inventory.
However, software held for licensing or rental to others should be recognized as an intangible asset. On the other hand, cost of software purchased by an entity for its own use and which is integral to the hardware (because without that software the equipment cannot operate), would be treated as part of cost of the hardware and capitalized as property, plant, or equipment. Thus, the cost of an operating system purchased for an in-house computer, or cost of software purchased for computer-controlled machine tool, are treated as part of the related hardware.
The costs of other software programs should be treated as intangible assets (as opposed to being capitalized along with the related hardware), as they are not an integral part of the hardware. For example, the cost of payroll or inventory software (purchased) may be treated as an intangible asset provided it meets the capitalization criteria under IAS 38.
In practice, the conservative approach would be to expense such costs as they are incurred, since their ability to generate future economic benefits will always be questionable. If the costs are capitalized, useful lives should be conservatively estimated (i.e., kept brief) because of the well-known risk of technological obsolescence. The next example may illustrate the principle, better. Read on…
Example Of Software Developed For Internal Use
The Dharma Tech Services Corp. employs researchers based in countries around the world. Employee time is the basis upon which charges to many customers are made. The geographically dispersed nature of its operations makes it extremely difficult for the payroll staff to collect time records, so the management team authorizes the design of an in-house, web-based timekeeping system. The project team incurs the following costs:
Thus, the total capitalized cost of this development project is $100,000 (the blue color). The estimated useful life of the timekeeping system is five years. As soon as all testing is completed, Dharma Tech’s controller begins amortizing using a monthly charge of $1,666.67. The calculation follows:
$100,000 capitalized cost / 60 months = $1,666.67 amortization charge
Once operational, management elects to construct another module for the system that issues an e-mail reminder for employees to complete their timesheets. This represents significant added functionality, so the design cost can be capitalized. The following costs are incurred:
Labor type Labor cost Payroll taxes Benefits Total cost
Software developers $11,000 $ 842 $1,870 $13,712
Quality assurance testers 7,000 536 1,190 8,726
Totals $18,000 $1,378 $3,060 $22,438
The full $22,438 amount of these costs can be capitalized. By the time this additional work is completed, the original system has been in operation for one year, thereby reducing the amortization period for the new module to four years. The calculation of the monthly straight-line amortization follows:
$22,438 capitalized cost / 48 months = $467.46 amortization charge
The Dharma Tech management then authorizes the development of an additional module that allows employees to enter time data into the system from their cell phones using text messaging.
Despite successfully passing through the concept design stage, the development team cannot resolve interface problems on a timely basis. Management elects to shut down the development project, requiring the charge of all $13,000 of programming and testing costs to expense in the current period.
After the system has been operating for two years, a Dharma Tech customer sees the timekeeping system in action and begs management to sell it as a stand-alone product. The customer becomes a distributor, and lands three sales in the first year. From these sales Dharma Tech receives revenues of $57,000, and incurs the following related expenses:
Distributor commission (25%) = $14,250
Service costs = $ 1,900
Installation costs = $ 4,300
Thus, the net proceeds from the software sale is $36,550 (= $57,000 revenue less $20,450 related costs). Rather than recording these transactions as revenue and expense, the $36,550 net proceeds are offset against the remaining unamortized balance of the software asset, with the following entry:
[Debit]. Revenue = $57,000
[Credit]. Fixed assets—software = $36,550
[Credit]. Commission expense = $14,250
[Credit]. Service expense = $1,900
[Credit]. Installation expense = $4,300
At this point, the remaining unamortized balance of the timekeeping system is $40,278, which is calculated as follows:
Original capitalized amount $100,000
+ Additional software module $ 22,438
– 24 month’s amortization on original capitalized amount (40,000)
– 12 month’s amortization on additional software module (5,610)
– Net proceeds from software sales (36,550)
Total unamortized balance $ 40,278
Immediately thereafter, Dharma Tech’s management receives a sales call from an application service provider who manages an Internet-based timekeeping system. The terms offered are so attractive that Dharma Tech abandons its in-house system at once and switches to the server system.
As a result of this change, the company writes off the remaining unamortized balance of its timekeeping system with the following entry:
[Debit]. Accumulated depreciation = $45,610
[Debit]. Loss on asset disposal = $40,278
[Credit]. Fixed assets—software =$85,888