Accounting for Internally Developed Software: Best Practices

1. ITFMA - Presentation Abstract In the presentation to follow the accounting guidelines for internally developed software will be discussed. The presenter will discuss the current financial accounting guidelines specifically FASB ASC 350-40, Internal-use software and how best to apply them. This discussion will be a thorough walk through of the guide and a discussion of ITFMA Best Practices to follow. The presenter will include a step by step guide as well as a detailed review of IT activities that are either expensed or capitalized in accordance with the accounting guidelines. The presenter will also conclude with a “Best Practices” approach including an IT activity guide and a working session review of an example project cost estimating template. The template is designed in accordance with the FASB guidelines.

2. About the Presenter Michael Kiely is currently a Sr. Director of IT Finance at Marriott Vacations Worldwide Corporation. He has over 20 years experience in IT Financial Management. In that time he has been an IT financial manager for two major corporations (e.g. Marriott and Lykes Services Inc.) He has worked as both an internal auditor for Lykes Services Inc. (e.g. Peoples Gas of Tampa, Lykes Steamship, Lykes Meats, Florida Gold Orange Juice, etc.) He has also worked as an external auditor for both Hacker, Johnson and KPMG. He is a Certified Public Accountant, Certified Information Technology Professional and a Certified Information Systems Auditor. In addition, he is an Associate Professor at Valencia College in Orlando Florida and is ABD in his PHD from Northcentral University.

3. FASB ASC 350-40Accounting for Internal-use software IT Financial Management Best Practices – Michael Kiely, CPA, CITP, CISA, PHD-ABD

4. Why do I care about best practices in the accounting for internally developed software? • It’s a complex accounting area and your friendly auditors know it’s a hot audit spot – • Capitalization of labor audits: Reviewing whether internal development software projects comply with FASB’s ASC 350-40 can give auditors a clear picture of the value IT projects deliver to the organization – Internal Auditor, Thomas, L (2010) • It’s necessary for understanding IT project investment and a company’s overall value! • SEC fraud is on the rise! – 2009 American Italian Pasta Company found in violation of Internal-use software guidelines by the SEC!

5. FASB ASC 350-40 • FASB Accounting Standards Codification Subtopic 350-40 (“ASC Subtopic 350-40”), Internal Use Software, is the primary source of authoritative guidance • Prior guidance came from legacy FASB Statement of Position No. 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use. Internal-use software is defined as having both of the following requirements:

6. Requirements for Internal-use software • 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 substantive plan exists or is being developed to market the software externally.

7. FASB Guidance follows the traditional Software Development Life Cycle (SDLC) • The accounting guidance divides the development of internal-use software into three stages: 1) preliminary project stage, 2) application development stage, and 3) post-implementation/operation stage. Examples of the activities that are performed during each stage are included below. • Preliminary Project Stage • Conceptual formulation of idea and alternatives • Evaluation of alternatives • Determination of existence of needed technology • Final selection of alternatives • Application Development Stage • Design of chosen path, including software configuration and interfaces • Coding • Installation of hardware • Testing, including parallel processing • Post-Implementation/Operation Stage • Training • Application maintenance

8. The activities performed in the Preliminary Project Stage are analogous to research and development activities and as such are expensed as incurred. Please see table below for detailed activities included in this stage.

9. Per FASB Accounting Standards Codification 350-40-25-2 through 5, internal and external costs incurred to develop internal-use software during the application development stage are capitalized. • Data conversion costs are expensed as incurred, with the exception of those costs to develop or obtain software that allows for access or conversion of old data by new systems, which are capitalized. • Training costs are not considered internal-use software development costs and, if incurred during this stage or any other stage, are expensed as incurred. • The capitalization rules should be applied based on the nature of the costs incurred rather than the timing of their occurrence.

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11. What costs can be capitalized during the Application Development Stage? Per FASB Accounting Standards Codification 350-40-30-1 capitalized costs include only the following: 1) External direct costs of materials and services consumed in developing or obtaining internal-use computer software. • Fees paid to third parties for software development services. • Costs incurred to purchase software from third parties. • Travel expenses incurred by employees directly associated with developing software. 2) Payroll and payroll-related costs (employee benefits) for employees who are directly associated with and who devote time to the internal-use software project to the extent of the time spent directly on the project. • Employee activities include coding and testing during this phase. 3) Interest costs incurred while developing internal-use software.

12. When should the capitalization of costs begin? Per FASB Codification 350-40-25-12, capitalization begins when both of the following occur: • The preliminary project stage has been completed, and • Management, with the relevant authority, authorizes (explicitly or implicitly) and commits to funding the project and it is probable that the project will be completed and the software will be used to perform the intended function. • Examples of authorization include the execution of a contract with a third party to develop the software, approval of expenditures related to internal development, or a commitment to obtain the software from a third party.

13. Can costs be capitalized during the Post Implementation/Operation Stage? Per FASB Accounting Standards Codification 350-40-25-6, internal and external training costs and maintenance costs during the post implementation/operation stage are expensed as incurred.

14. What costs can be capitalized during the Post Implementation/Operation Stage? Per FASB Accounting Standards Codification 350-40-25-7 through 11, in order for costs of specified upgrades and enhancements to internal-use computer software to be capitalized, it must be probable that those expenditures will result in additional functionality. • Internal costs incurred for maintenance are expensed as incurred. • Entities that cannot separate internal costs between maintenance and minor upgrades and enhancements should expense the costs as incurred. Summary Approach: Costs related to upgrades and enhancements that increase functionality should be capitalized. Routine maintenance activities and minor upgrades or enhancements that do not increase functionality should be expensed.

15. Can costs be capitalized for Website Development? • FASB Accounting Standards Codification 350-50 provides guidance for the capitalization of costs for Website Development. General guidelines are the following; • Expense costs that are related to activities involved in the planning, content development and operating stages. • Capitalize those costs involved in the Web site application and infrastructure development stage. Some exceptions exist in the above but are rare. Look to the FASB for more detailed guidance. Also if the website is marketed externally rather than for internal needs look to the guidance of FASB ASC 985-20.

16. What other IT related costs can be capitalized? Additionally upgrades and enhancements to existing software should be expensed, unless it is probable that the expenditures will increase functionality or significantly extend the useful life of the existing software. Increased functionality is defined as changes to the software so that it may perform a task that it is currently unable to perform. Upgrades and enhancements that provide additional functionality and meet the capitalization minimum can be capitalized. Software and licenses acquired should be capitalized and amortized over the life of the license.

17. What if we do Agile Software Development? • Best Practices don’t exist in the area of capitalizing internal development when following the agile software development methodology. (The FASB follows the traditional SDLC model only!) • Ask your team if they are truly following the Agile Methodology? – Its great to say your following agile for Internal-use but are you really?? Traditionally the agile method has been used for external software development which will eventually be marketed for sale. (e.g. Microsoft, Apple, Oracle, etc.) If so you need to follow separate FASB guidance on externally marketed software! • Some companies that are in fact using agile for internal-use development decided to capitalize only work and costs that occur as part of testing. (e.g. IBM, etc.) – Take a conservative approach!

18. Best Practices – In following FASB ASC 350-40 • Tie the FASB to your Software Development Policy! • Review Software Development Policy yearly with CIO, PMO, PM’s and Senior Level IT Management. • Develop IT Project Estimate template that summarizes cost by SDLC and provides Financial Management with an Expense and Capital total for the project. – See example Cost Estimate Template provided in Summary Session. • Regular Communication with IT Financial Manager and Project Management team on cost and stage of project. - (e.g. Understand Movement Between Stages)

19. Summary Review Session • Group Review of Sample Guide for Project Managers and IT Financial Managers in determining Expense vs Capitalize. – Appendix IT Activity Guide • Audience Session Question: What methods do you use to determine the phase of the project?