SaaS Companies. What Costs Should Be Capitalized? Introduction

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1 SaaS Companies What Costs Should Be Capitalized? Introduction An increasing number of new and established software companies are becoming more sassy, delivering Software as a Service ( SaaS ) and replacing the software licensing model. (The benefits to the SaaS customer are obvious reduced capital expenditures and IT support costs.) Although SaaS companies are increasingly taking advantage of the new multiple element revenue rules 1 to accelerate non-subscription (e.g. professional services) revenues, there seems to be diversity in practice among the public SaaS companies when it comes to capitalizing expenses. Armanino McKenna conducted a survey of 47 public SaaS companies to examine their accounting policies for certain expenses. The results showed 70% of those SaaS companies are capitalizing expenses - the two most common expenses capitalized are software development expenses and sales commissions. To understand the diversity in capitalization practices, we examined the rules for capitalizing these and other SaaS expenses. 1 FASB ASC Subtopic 605-5, Revenue Recognition Multiple-Element Arrangements 1

2 SaaS Expenditures/Capitalization Costs The table below lists the more common SaaS expenditures and our interpretation of the rules on capitalizing or expensing such costs. It is not meant to be all inclusive but highlights the more common SaaS expenditures associated with the development and maintenance of software and/or website applications. Type of Software Development Expenses Portion of Expenditures Eligible for Capitalization Portion to Expense 1 Salaries and employee benefits for software and website developers/engineers Internal use software and related costs, such as developing or obtaining software that allows for access to or conversion of old data by new system Fees paid to outside providers for software development 4 Develop website graphics 5 6 Interest costs associated with loans used to fund software development or purchase software under a capital lease Indirect costs--overhead facilities (i.e., rent, utilities, etc.) After technological feasibility or application development stage but before general release NOTE: Upgrades/enhancements, including those related to a website, must be probable of providing additional functionality Percent attributable to development meeting capitalization criteria An allocated amount related to software development after technological feasibility or application development stage but before general release Costs incurred to establish technological feasibility 4 (i.e., purchased software, application, and/or website planning costs) and costs incurred after general release (i.e., release of bug fixes, patches, inputting website content, website data conversion, registering with an internet search engine, etc.) 7 Website-obtain and register internet domain All costs capitalized as other intangibles Not applicable 8 General and administrative department costs 9 Training-internal and external Maintenance costs, such as 1) keeping systems software current with revisions in hardware, ) correcting errors, ) localizing/translating software and 4) other routine changes and additions Customer support department costs, such as 1) services to assist customers, ) installation assistance, ) telephony support, 4) newsletters, 5) onsite visits, 6) and software or data modifications One-time start-up costs, such as 1) introducing a new product/service, ) conducting business in a new territory or with a new class of customers, or ) commencing some new operation Website hosting, such as monthly fees paid to co-location providers 14 Purchased software Not applicable Purchased software with alternative future use (i.e., for use in developing software for direct resale or developing a website) with amortization over the expected period of use As incurred Purchased software with no alternative future use accounted for as internal use software 5 Under ASC , Costs of Software to Be Sold, Leased or Marketed, technological feasibility is established when the entity has completed all planning, designing, coding, and testing activities that are necessary to establish that the product can meet its designed functions, features, and technical performance requirements. ASC Subtopic , Internal Use Software, defines the application development stage as the point at which the company completes the initial project setup and management implicitly or explicitly authorizes and commits to funding and completing a computer software project 4 Expense as research and development in accordance with ASC 70-10, Research and Development-Overall 5 Under ASC , such software costs would only be capitalizable during the application development stage and prior to general release

3 Capitalized costs of developed software to be marketed or leased externally are amortized on a productby-product basis over the greater of a) percent of current year revenues/total forecast revenues or b) the straight-line method over the remaining estimated useful life. Capitalized costs related to internal use software are generally amortized on a straight-line basis. Product enhancements are generally amortized on a straight-line basis over the useful life of the enhancement. Software development costs are typically categorized as research and development expenses. Incremental Expenses The table below highlights incremental expenses incurred outside of the development process. Type of Service Expenses 1 Internal and external sales commission 4 Costs of acquiring contracts, including 1) due diligence activities after competitive selection, ) evaluation of customers credit rating and ) preparation and processing documentation of the transaction Post-contract set-up costs, including 1) setting up customer accounts, ) installation of systems and processes to support the acquired contract, and ) accumulating and converting data Costs of delivering professional services related to subscription agreements 5 Advertising 6 Technology or software licensing/ royalty fee Portion of Expenditures Eligible for Capitalization Commissions can be deferred and amortized to sales expense over the term of the related subscription period as long as the commission is paid only for successful efforts and the agreement contains a clawback provision the company intends to enforce. Both practice and SEC staff accept capitalization of incremental direct set-up and similar costs incurred after a contract is obtained, amortizing on a straight-line basis over the service/contract term 6 Defer when professional services revenue cannot be separately recognized, amortizing over the same period as professional service revenue 7 May select a policy to defer and expense upon the first time advertising takes place (i.e., first showing/ appearance of TV or magazine ad) 1. Prepayments for time based licenses. Perpetual licenses Portion to Expense As incurred is always acceptable for such costs. The policy should be selected based on an analysis of the arrangements and the costs incurred, rather than on a goal of capitalizing (or expensing) a certain amount of costs. Not applicable As incurred if professional services revenue can be recognized separately from subscription revenues 7 Expensing all advertising costs is an acceptable alternative policy to deferral NOTE: Accounting policy must be consistently applied to similar kinds of advertising activities Usage based royalty payments expensed as reported to licensor 6 ASC S99, Af, Question 4, Revenue Recognition-SEC Materials, analogizes the capitalization for these types of costs to the accounting treatment for loan origination fees as outlined in ASC , Receivables-Nonrefundable Fees and Other Costs, and warranty/maintenance contracts as outlined in ASC , Revenue-Services 7 Under ASC , Multiple-Element Arrangements, professional services cannot be separated, unless 1) the item can be sold separately by any vendor or the customer could resell the services themselves; and ) there is evidence of the fair value of the services (i.e., price when sold separately)

4 Lack of Capitalizing Expenses Reasoning Like all assets, deferred costs must be evaluated for realizability. Some companies have essentially eliminated the need for a realizability test by adopting a policy of deferring costs only to the extent of deferred revenues. This policy is less preferable than one that adopts a full cost deferral model or expenses all costs as incurred. However, a policy of deferring direct costs to the extent of deferred revenues is acceptable, if applied consistently. Regardless of the decision to capitalize or expense, companies should appropriately disclose their choice of accounting policy. Considering 70% of surveyed companies are capitalizing costs, a question arises as to why more companies are not taking advantage of the capitalization rules. We ve determined the lack of capitalizing SaaS expenses can be attributed, in part, to the following: A short period between technological feasibility (or application development stage) and general release Lower cost, more powerful development tools have created low barriers to entry, resulting in intense competition, accelerating the pace of application development, shortening the time frame between technological feasibility and release. This period can be so brief that any costs eligible for capitalization are nominal. Additionally, the rapidly changing application and software development marketplace makes it more likely that management will terminate projects the minute the market trends have shifted. 4

5 The lack in understanding of which costs must versus may be expensed Under the accounting rules, certain SaaS costs must be expensed, while other costs may be capitalized based upon policy elections made by management. Understanding the nuances in the accounting literature can be unclear, confusing and complicated. For example, companies may capitalize an allocated amount of indirect costs related to software development, such as rent and utilities. However, the same companies must fully expense general and administrative expenses. As a result, companies may err on the side of conservatism, choosing to expense these costs rather than investing time in developing a SaaS capitalization policy. The impracticality in separating capitalizable SaaS expenses from other costs As noted in the table prior, there are several types of SaaS expenses which are eligible for capitalization. For certain companies, the time and cost of identifying and separating these expenses outweighs any benefit to be received from capitalization. For example, the percent of loan interest cost attributable to the software development may be capitalized. However, separating these costs may become impractical for certain companies based on the specificity required for capitalization. Companies may also find their accounting system is incapable of accurately identifying and separating costs, thereby creating another reason not to invest time in separating these expenditures. The lack of resources to track SaaS expenditures eligible for capitalization Considering recent economic conditions, accounting and finance departments have been reluctant to add head count. A lean accounting and finance department could act as a barrier to developing or modifying a SaaS capitalization policy, identifying such costs in the accounting system and tracking and accounting for these expenditures. Moreover, other companies may not be willing to invest in the resources necessary to properly capitalize and account for SaaS expenditures. 5

6 Best Practice Recommendations SaaS companies should continually evaluate the decision on when to capitalize versus expense software development and other incremental costs as there are several short and long term implications. They should also consult with an accounting professional with expertise in SaaS revenue and expense recognition to fully understand the alternatives, and ultimately adopt the method they believe most closely follows the spirit of the accounting rules. A complete copy of the public company SaaS Cost Capitalization Database can be obtained by answering five quick questions at: View a sample of the survey database on the following page. Armanino McKenna 50 W. San Fernando St. Suite 600 San Jose, CA Matt Perreault is a Partner with Armanino McKenna, a Top 40 CPA and Consulting firm, and is a recognized subject matter expert in the areas of SaaS and software revenue recognition, equity accounting and public company reporting rules. Contact Matt at [email protected] or (95) Ricardo D. Martinez is a Senior Manager with Armanino McKenna and has over 1 years of experience conducting audit and advisory services predominantly in the technology industry including seminconductor, software, internet and online educational segments. Contact Ricardo at [email protected] or (95) x7010 6

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