Welcome to Internally Developed Software!
Hello there! Ready to dive into one of the most practical parts of the BAR exam? In today’s world, almost every company is a "tech company" in some way. Whether a business is building an app to sell to customers or just creating a custom portal for its employees to track their hours, they are spending money on internally developed software.
As a CPA, your job is to figure out: "Is this an expense that hits the income statement immediately, or is it an asset we can put on the balance sheet and spread out over time (capitalization)?" Don't worry if this seems tricky at first—we’re going to break it down stage by stage!
1. The Two Main Paths
Before we look at the numbers, we have to ask: Who is the software for? The accounting rules change depending on the answer.
- Internal Use Software: Software developed solely for the company’s internal needs (e.g., an internal accounting system or a HR portal).
- Software to be Sold, Leased, or Marketed: Software developed as a product to generate revenue (e.g., a video game or a cloud-based SaaS platform sold to others).
Quick Review: If you are building it for yourself, follow the "Internal Use" rules. If you are building it to sell it, follow the "External Sale" rules.
2. Internal Use Software (ASC 350-40)
Think of building internal software like building a new deck on your house. You don't just start hammering; there’s a process. For accounting, we break this into three stages. Use the mnemonic "P.A.P." to remember them!
Stage 1: Preliminary Project Stage
This is the "brainstorming" phase. You are looking at alternatives, choosing vendors, and deciding if the project is even possible.
Accounting Treatment: EXPENSE everything. At this point, we aren't sure if a "deck" will ever actually exist.
Stage 2: Application Development Stage
This is where the magic happens! You are coding, installing hardware, and testing the software.
Accounting Treatment: CAPITALIZE these costs. You are creating a long-term asset.
Criteria to start capitalizing: You must have completed the Preliminary stage and management must be committed to funding the project because it is probable it will be completed and used.
Stage 3: Post-Implementation/Operation Stage
The software is live! Now you are just doing routine maintenance and training employees.
Accounting Treatment: EXPENSE everything. Training and maintenance do not "improve" the asset; they just keep it running.
Did you know? Training costs are always expensed, even if they happen during the development stage. You can't capitalize a human's knowledge!
3. Software to be Sold, Leased, or Marketed (ASC 985)
When software is the product, the rules get a bit stricter. The big "turning point" here is a concept called Technological Feasibility.
The "Before" and "After" of Technological Feasibility
Technological Feasibility is established when you have a detailed program design or a working model. It means you’ve proven the software can actually do what it’s supposed to do.
- Before Technological Feasibility: All costs are considered Research & Development (R&D) and must be EXPENSED.
- After Technological Feasibility (until the product is released): Costs are CAPITALIZED as an inventory-like asset.
- After General Release to Customers: Stop capitalizing. New costs are now production costs or maintenance.
Amortizing External Software
Once the software is sold, you must amortize (expense) the capitalized costs. You must use the greater of two calculations:
- Percentage of Revenue Method: \( \text{Total Capitalized Cost} \times \left( \frac{\text{Actual Revenue for Period}}{\text{Total Expected Revenue}} \right) \)
- Straight-Line Method: \( \frac{\text{Total Capitalized Cost}}{\text{Remaining Economic Life}} \)
Example: If the Revenue method gives you \$10,000 and the Straight-Line method gives you \$12,000, you must record \$12,000 in amortization expense. The goal is to be conservative and not overstate the asset's value.
4. Cloud Computing Arrangements (SaaS)
In the modern world, many companies don't "buy" software; they "rent" it via the cloud (Software as a Service).
The Golden Rule: If the contract does not give the customer the right to take possession of the software, it is a Service Contract.
- You expense the service fees as they are incurred.
- However, if there are "implementation costs" (like coding a custom interface for your cloud portal), you follow the Internal Use Software rules mentioned above (capitalize the development stage costs!).
5. Summary Table & Key Takeaways
To keep it simple, look at this "Cheat Sheet":
| Topic | Expense Stage | Capitalize Stage |
|---|---|---|
| Internal Use | Preliminary & Post-Implementation | Application Development |
| To Be Sold | Before Technological Feasibility (R&D) | After Tech Feasibility until Release |
| Cloud (SaaS) | Monthly service fees | Implementation costs (if complex) |
Common Mistake to Avoid: Don't confuse "Technological Feasibility" (External Use) with "Management Commitment" (Internal Use). The BAR exam loves to swap these terms to trip you up!
Key Takeaway:
The "middle" part of the process is almost always what you capitalize. The "beginning" (planning/research) and the "end" (maintenance/training) are almost always expensed. If you are selling the software, remember to run the "Greater of" amortization test!
Keep going! Accounting for software might feel "intangible," but once you master the timing of these stages, you'll be coding your way to a passing score!