Accounting for Software Development Costs: Insights from PwC

In today’s digital age, software is a critical asset for most businesses. As companies increasingly invest in software development to stay competitive, the accounting treatment of these costs has gained significant attention. The complexity arises from the fact that software development can be both an asset that adds long-term value and an expense. Proper accounting for these costs ensures that a company’s financial statements accurately reflect its financial health. PricewaterhouseCoopers (PwC), one of the "Big Four" accounting firms, offers a robust framework for understanding the principles and nuances of software development cost accounting.

This article provides a deep dive into how PwC suggests accounting for software development costs, considering both internal use and external sale software. It will explain the GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards) frameworks, outline key distinctions between different types of software, and provide examples to highlight these guidelines.

Understanding Software Development Costs

Software development costs can broadly be divided into two categories:

1. Internal-use software
2. Software developed for external sale or licensing

Each category has its unique accounting treatment, especially in terms of capitalization and expense recognition.

1. Internal-use Software

Internal-use software is developed for the company's operational needs, such as customer relationship management (CRM) systems, payroll management, and inventory control systems. According to ASC 350-40 under U.S. GAAP, companies should follow three stages when accounting for internal-use software:

• Preliminary Project Stage: Costs incurred in the early stages, such as planning and feasibility studies, should be expensed as they occur.
• Application Development Stage: Once the project passes feasibility, costs related to coding, testing, and integration may be capitalized as part of the software’s asset value.
• Post-Implementation Stage: Costs after implementation, such as maintenance and bug fixes, are to be expensed immediately.

Capitalization Window: The window for capitalizing costs is key. A company can only capitalize expenses incurred during the application development stage. This is typically the most substantial part of the cost, as it involves labor, hardware integration, and testing. PwC emphasizes careful tracking of these costs to ensure accuracy in financial reporting.

2. Software Developed for Sale or Licensing

Software developed for external customers is treated differently. ASC 985-20 under U.S. GAAP lays out specific guidelines:

• Costs incurred before technological feasibility is established are to be expensed. Technological feasibility is generally considered achieved when a detailed design plan is completed and tested.
• Costs incurred after reaching technological feasibility and before the software is ready for sale are capitalized.
• Once the product is available for general release to customers, subsequent costs are expensed.

Key Considerations:

• Technological Feasibility: Defining the exact point at which feasibility is achieved can be subjective, but PwC advises using measurable milestones to ensure consistency.
• Maintenance and Upgrades: Ongoing costs related to software updates or additional features post-release should be expensed unless they provide new functionalities or significant performance enhancements.

Impact of Cloud Computing on Software Accounting

The rise of cloud computing and Software as a Service (SaaS) has added layers of complexity to accounting for software development. In the past, most software was sold as a one-time product, but now it’s often offered as a subscription service. Under ASC 350-40, internal-use software hosted on a cloud infrastructure (SaaS) is treated differently. Here, companies often expense costs related to accessing third-party cloud services, while any customizations to the platform may be capitalized.

PwC’s Best Practices for Cloud Computing Costs:

• Subscriptions: Costs associated with software subscriptions or licenses for accessing cloud platforms are typically expensed as incurred.
• Customizations: If a company customizes the cloud platform for its use, these costs may be capitalized.
• Implementation Services: Implementation costs, including software configuration and customization, are capitalized if they add value over the software’s expected life.

Practical Examples

Consider a retail company developing an e-commerce platform for internal use. In the preliminary project stage, the company engages in brainstorming and market analysis to determine the platform’s potential value. All costs in this stage are expensed. During the application development stage, they hire developers, purchase hardware, and begin coding the platform. These costs are capitalized. Once the platform is launched, any maintenance costs are expensed.

In contrast, a software company developing a new video editing tool for external sale might incur significant R&D costs before achieving technological feasibility. These early expenses are immediately recognized. After the feasibility stage, costs related to coding and testing the tool are capitalized until the product’s general release.

Key Differences Between GAAP and IFRS

One of the significant differences between GAAP and IFRS in accounting for software development costs is the treatment of research costs. Under IFRS, research costs are expensed, while development costs that meet certain criteria may be capitalized. The criteria for capitalizing under IFRS (IAS 38) include:

• The technical feasibility of completing the software for use or sale.
• The intention to complete and use or sell the software.
• The ability to use or sell the software.
• The availability of resources to complete the project.

These requirements align with the principles under U.S. GAAP but may result in different timing for capitalization and expense recognition.

Potential Pitfalls and Risks

While proper accounting for software development costs is critical, companies must also be aware of potential pitfalls. PwC identifies the following risks:

1. Misclassifying expenses: Failure to distinguish between the preliminary and development stages can result in the incorrect capitalization of costs.
2. Overestimating useful life: Overestimating the useful life of a software product can lead to improper amortization schedules, affecting future profitability.
3. Impairment Testing: If a software product is not expected to generate the previously anticipated benefits, an impairment loss may need to be recognized, reducing the software's carrying value.

Conclusion

Properly accounting for software development costs is essential for accurate financial reporting. Whether software is developed for internal use or external sale, the guidelines set by GAAP and IFRS offer a clear framework for capitalization and expense recognition. PwC’s insights emphasize the importance of defining technological feasibility, tracking expenses during different stages, and adapting to new trends like cloud computing. Following these best practices ensures that a company's financial statements accurately reflect its software investments and provide stakeholders with a clear picture of its financial health.