Accounting to the Rescue

• By Larry Goldstein
• 03/31/05

An oft-overlooked accounting standard could be your key to better project cost management.

You may not know it, but there is an accounting standard that should be of interest to you and your CFO; it presents a valuable resource for both technologists and accountants. Unfortunately, in my experience, relatively few CFOs and even fewer CIOs are aware of the standard’s existence and, more importantly, they are blissfully unaware of how it can help an institution spread the cost of major technology projects over multiple budget periods. The standard is the American Institute of Certified Public Accountants’ Statement of Position 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use (SOP 98-1). Though issued in 1998, the provisions of SOP 98-1 were not effective until the fiscal year ended in 2000. And although technically applicable only to independent colleges and universities, the National Association of College and University Business Officers (NACUBO) issued an advisory report encouraging all higher education institutions to follow the standard. Still, despite the fact that that standard was issued so long ago, I frequently encounter campus executives who are not familiar with its provisions.

What is SOP 98-1?

As suggested by its title, SOP 98-1 addresses accounting for software developed or otherwise acquired for internal use. The standard isn’t concerned with desktop application software such as Microsoft Office or Crystal Reports. Instead, think ERP—whether purchased as a package or homegrown. Everyone recognizes that massive sums are invested in these applications; the issue is whether to treat the investment as a capital asset (e.g., a building) or as an expense of the current period (e.g., travel to a conference). For years, there was no guidance in this area. What SOP 98-1 d'es is standardize how organizations measure and report their investment in large-scale computer software.

In fact, SOP 98-1 addresses various categories of investment related to internal-use computer software, and establishes guidelines for determining which costs should be treated as a current period expense, and which costs should be capitalized and charged to future periods through amortization. This is analogous to how investments in other major assets are handled. For instance, assume a truck costs $50,000 and is expected to provide service for 10 years. Rather than treat the initial purchase price as an expense in the year it’s acquired, the $50,000 is recorded as an asset and $5,000 is recognized as depreciation expense each of the next 10 years. From a budgeting standpoint, isn’t $5,000 much easier to cover than $50,000?

How It Works

Costs related to software projects are classified by SOP 98-1 based on the phase in which they’re incurred. The three phases include: 1) preliminary project stage, 2) application development stage, and 3) post-implementation/operation stage. During the preliminary project phase, costs are incurred as various alternatives are identified, evaluated, and a final selection is made. The development stage includes acquisition and customization (or coding, if homegrown), installation, and testing. The post-implementation operation phase includes training and application maintenance.

Stage One: Preliminary. Under the accounting standards established in SOP 98-1, all costs sustained during the preliminary project stage are to be expensed during the period in which they occur. The preliminary project stage is a time for researching alternatives and considering various options. Costs incurred at this stage do not increase the cost of the application (which, if they did, might then be amortized. In fact, this prevents that kind of cost/amortization.) This treatment is consistent with the general principal that research and development costs must be expensed immediately. Costs incurred in this phase include a wide range of items, such as travel to visit peers currently using alternatives under consideration, consulting fees paid to outsiders engaged to help with the selection process, and costs related to the RFP process.

Stage Two: Application Acquisition. Once the decision is made to acquire a specific application, the costs involved are isolated and accumulated so they can be capitalized. This is true for amounts paid to a vendor, as well as to salaries and benefits paid to staff working directly on the project. However, as in the planning phase above, some costs incurred in this phase must be expensed and cannot be counted as part of the application’s capitalized cost. For instance, any training costs that might crop up during this phase must be expensed. On the other hand, the purchase of software needed in order to convert existing data, represents a capitalizable cost. Other data conversion costs also should be capitalized as part of the project. Similarly, consulting fees for assistance during implementation—either for customization or project management—are appropriately capitalizable. Campuses also should capitalize the payroll and payroll-related costs for staff assigned to the project, as well as the expenses incurred for project-team travel to conferences related to the project. (The exception to this general rule is for effort related to training which, as explained above, should be expensed.)

Stage Three: Post-Implementation. Costs occurring in the post-implementation/operation stage, typically training and maintenance costs, should be treated as an expense during the period in which they’re incurred. There is one exception to the general rule that post-implementation/operation stage costs should be expensed: If upgrade and/or enhancement costs are acquired following implementation—and they add new functionality—the costs should be added to the application cost already capitalized. This will increase the annual amortization for the remaining life of the application.

More Help from SOP 98-1

SOP 98-1 also establishes standards for determining when the application development stage actually begins and ends. Two events must occur for the development stage to commence: 1) The preliminary project stage must end (i. e., a decision must be made), and 2) management must commit funding to the project. Once both have occurred, the costs become subject to capitalization. Costs will continue to be capitalized until the post-implementation/operation phase is reached, unless it becomes apparent that the project will not be completed and placed in service. If that should happen, amounts previously capitalized are recognized as a loss. Under normal circumstances, however, the application development stage ends when the software project is substantially complete and ready for its intended use. The trigger identified in the standard is the completion of testing. At this point, any additional costs that are incurred should be expensed.

Adherence to the standard can provide significant benefits. First, by following the provisions of the standard, institutions can make meaningful comparisons with others following the standard. Second, and possibly of greater importance, the fact that many significant costs can be capitalized rather than charged against the current budget means that investment in expensive projects can be spread out over the anticipated useful life of the project. For instance, ERPs frequently take several years to implement and are expected to provide service for many years. Rather than charge all of the up-front costs to the current year budgets, it’s much more reasonable and manageable to accumulate the costs, capitalize then, and amortize them over the entire useful life of the ERP. Bottom line? It pays to get to know SOP 98-1.