Accounting concerns when purchasing an internal-use software license

Oct 25, 2019
Financial management Accounting compliance

Software intended only for internal use can include back-office systems used for accounting, research, project management, customer service and the like. Such software is either developed internally, purchased off the shelf or modified to a company’s specifications.

In determining what software to purchase, managers usually consider qualitative factors such as the features and functionality of the software, the reputation and name brand of the software vendor, the level and quality of post‑implementation support, and the compatibility with existing data and business systems. Though software-as-a-service, (SaaS), arrangements are rising in popularity, many managers may prefer to purchase an on premise perpetual or term software license in certain situations.

There are, however, accounting issues that also need to be taken into consideration when purchasing and implementing a software license.

Software licensing arrangements frequently come with multiple elements or deliverables. For example, an arrangement might include the software license itself as well as technical support, rights to unspecified, when-and-if-available software updates, training or implementation services. These deliverables are accounted for in different ways. Managers generally must determine the amount of the contract consideration to allocate to each element which will require obtaining objective evidence of fair value for each element.

Managers should consider the following three stages to determine the proper accounting treatment:

1. Purchasing decision

These costs are associated with activities such as determining the functionality and features needed, identifying potential software solutions, meeting with potential vendors or value-added resellers for demos and determining the level of support needed to implement the solution. These upfront costs are expensed as incurred.

2. Implementation

The implementation period begins once the evaluation of software has been completed; a purchasing decision has been made and management has committed funds to the project.

The cost allocated to the software license, whether purchased on a perpetual or term basis, is capitalized as an intangible asset. Managers may also recognize a liability to pay for it over time, unless the license is prepaid. Most costs incurred related to software implementation activities—including customizing, configuring and installing—are capitalized along with the software license intangible asset. This would include not only fees paid to the third-parties for development and/or implementation services, but also payroll costs for employees directly working on the project also are capitalized. Capitalization is not an election but a requirement under the guidance. As a result, companies must have appropriate process and documentation in place to capture and evaluate these costs, especially payroll costs for employees related to implementation activities.  The resulting intangible asset, inclusive of the costs allocated to the software license and capitalized software development and implementation costs, is amortized over the useful life of the software commencing upon when the software is ready for its intended use.Any amounts allocated to post-customer support is recorded as a prepaid asset and then expensed over the period of the related software.

Certain other costs incurred prior to go-live on the new software license, such as the cost allocated to training, data conversion and business process reengineering, are all expensed as incurred.

3. Post Implementation

Once the system has gone live, the costs, such as those associated with training and maintenance, are expensed as incurred. The costs associated with upgrades and enhancements that result in significant additional functionality and are distinct from the maintenance cost, however, should be considered using the analysis above.

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