1. SaaSCompaniesWhat CostsShould BeCapitalized?IntroductionAn increasing number of new and established software companies are be-coming more sassy, delivering Software as a Service (SaaS) and re-placing the software licensing model. (The benefits to the SaaS customerare obviousreduced capital expenditures and IT support costs.) AlthoughSaaS companies are increasingly taking advantage of the new multiple ele-ment revenue rules1 to accelerate non-subscription (e.g. professional ser-vices) revenues, there seems to be diversity in practice among the pub-lic SaaS companies when it comes to capitalizing expenses. ArmaninoMcKenna conducted a survey of 47 public SaaS companies to examinetheir accounting policies for certain expenses. The results showed 70% ofthose SaaS companies are capitalizing expenses - the two most commonexpenses capitalized are software development expenses and sales com-missions. To understand the diversity in capitalization practices, we exam-ined the rules for capitalizing these and other SaaS expenses.1FASB ASC Subtopic 605-25, Revenue Recognition Multiple-Element Arrangements1SaaS Companies: What Costs Should Be Capitalized?

2. SaaS Expenditures/Capitalization CostsThe table below lists the more common SaaS expenditures and our interpretation of the rules on capital-izing or expensing such costs. It is not meant to be all inclusive but highlights the more common SaaSexpenditures associated with the development and maintenance of software and/or website applications.Portion of ExpendituresType of Software Development Expenses Portion to ExpenseEligible for Capitalization Salaries and employee benefits for software and1 After technological feasibility2 or appli- website developers/engineerscation development stage3 but before Internal use software and related costs, such as general release2developing or obtaining software that allows forCosts incurred to establish access to or conversion of old data by new system technological feasibility4NOTE: Upgrades/enhancements, (i.e., purchased software, Fees paid to outside providers for softwareincluding those related to a website,application, and/or website3 must be probable of providing addi- development planning costs) and costs in-tional functionality curred after general release4Develop website graphics (i.e., release of bug fixes, Interest costs associated with loans used to fund patches, inputting websitePercent attributable to development5software development or purchase software content, website data con-meeting capitalization criteria under a capital lease version, registering with anAn allocated amount related to soft- internet search engine, etc.) Indirect costs--overhead facilities (i.e., rent, ware development after technological6 utilities, etc.) feasibility or application developmentstage but before general release7Website-obtain and register internet domainAll costs capitalized as other intangiblesNot applicable8General and administrative department costs9Training-internal and external Maintenance costs, such as 1) keeping systems software current with revisions in hardware, 2)10 correcting errors, 3) localizing/translating soft- ware and 4) other routine changes and additions Customer support department costs, such as 1) services to assist customers, 2) installation11 assistance, 3) telephony support, 4) newsletters,Not applicableAs incurred 5) onsite visits, 6) and software or data modifica- tions One-time start-up costs, such as 1) introducing a new product/service, 2) conducting business in a12 new territory or with a new class of customers, or 3) commencing some new operation Website hosting, such as monthly fees paid to13 co-location providersPurchased software with alternative Purchased software withfuture use (i.e., for use in developing no alternative future use14 Purchased software software for direct resale or developing accounted for as internal usea website) with amortization over the software5expected period of use2Under ASC 985-20-25, Costs of Software to Be Sold, Leased or Marketed, technological feasibility is established when the entity has completed all planning, designing, coding, and testingactivities that are necessary to establish that the product can meet its designed functions, features, and technical performance requirements.3ASC Subtopic 350-40-25, Internal Use Software, defines the application development stage as the point at which the company completes the initial project setup and management implicitly orexplicitly authorizes and commits to funding and completing a computer software project4Expense as research and development in accordance with ASC 730-10, Research and Development-Overall5Under ASC 985-20-25, such software costs would only be capitalizable during the application development stage and prior to general release2SaaS Companies: What Costs Should Be Capitalized? 3. Capitalized costs of developed software to be marketed or leased externally are amortized on a product-by-product basis over the greater of a) percent of current year revenues/total forecast revenues or b) thestraight-line method over the remaining estimated useful life. Capitalized costs related to internal usesoftware are generally amortized on a straight-line basis. Product enhancements are generally amortizedon a straight-line basis over the useful life of the enhancement. Software development costs are typi-cally categorized as research and development expenses.Incremental ExpensesThe table below highlights incremental expenses incurred outside of the development process.Portion of ExpendituresType of Service ExpensesPortion to ExpenseEligible for Capitalization As incurred is always accept-Commissions can be deferred and amortizedable for such costs. The policyto sales expense over the term of the relatedshould be selected based onsubscription period as long as the commission is an analysis of the arrange-1 Internal and external sales commissionpaid only for successful efforts and the agree-ments and the costs incurred,ment contains a clawback provision the company rather than on a goal ofintends to enforce.capitalizing (or expensing) a certain amount of costs.Costs of acquiring contracts, includ-ing 1) due diligence activities aftercompetitive selection, 2) evaluation of2customers credit rating and 3) prepara- Both practice and SEC staff accept capitalizationtion and processing documentation ofof incremental direct set-up and similar coststhe transaction incurred after a contract is obtained, amortizingNot applicablePost-contract set-up costs, including on a straight-line basis over the service/contract1) setting up customer accounts, 2) term63 installation of systems and processes tosupport the acquired contract, and 3)accumulating and converting dataAs incurred if professionalDefer when professional services revenue cannotCosts of delivering professional services services revenue can be4 be separately recognized, amortizing over therelated to subscription agreementsrecognized separately fromsame period as professional service revenue 7subscription revenues7 Expensing all advertising costs is an acceptable alterna- tive policy to deferralMay select a policy to defer and expense upon5 Advertising the first time advertising takes place (i.e., first NOTE: Accounting policy mustshowing/ appearance of TV or magazine ad) be consistently applied to similar kinds of advertising activities Usage based royalty pay-Technology or software licensing/ 1. Prepayments for time based licenses6ments expensed as reportedroyalty fee 2. Perpetual licenses to licensor6ASC 605-10-S99, A3f, Question 4, Revenue Recognition-SEC Materials, analogizes the capitalization for these types of costs to the accounting treatment for loan origination fees asoutlined in ASC 310-20-35, Receivables-Nonrefundable Fees and Other Costs, and warranty/maintenance contracts as outlined in ASC 605-20-25, Revenue-Services7Under ASC 605-25-25, Multiple-Element Arrangements, professional services cannot be separated, unless 1) the item can be sold separately by any vendor or the customer could resell theservices themselves; and 2) there is evidence of the fair value of the services (i.e., price when sold separately)3SaaS Companies: What Costs Should Be Capitalized? 4. Lack of Capitalizing Expenses ReasoningLike all assets, deferred costs must be evaluated for realizability. Some companies have es-sentially eliminated the need for a realizability test by adopting a policy of deferring costsonly to the extent of deferred revenues. This policy is less preferable than one that adoptsa full cost deferral model or expenses all costs as incurred. However, a policy of deferringdirect costs to the extent of deferred revenues is acceptable, if applied consistently. Re-gardless of the decision to capitalize or expense, companies should appropriately disclosetheir choice of accounting policy.Considering 70% of surveyed companies are capitalizing costs, a question arises as to whymore companies are not taking advantage of the capitalization rules. Weve determined thelack of capitalizing SaaS expenses can be attributed, in part, to the following:A short period between technological feasibility (or application development stage)and general releaseLower cost, more powerful development tools have created low barriers to entry, result-ing in intense competition, accelerating the pace of application development, shorteningthe time frame between technological feasibility and release. This period can be so briefthat any costs eligible for capitalization are nominal. Additionally, the rapidly changingapplication and software development marketplace makes it more likely that manage-ment will terminate projects the minute the market trends have shifted. 4 SaaS Companies: What Costs Should Be Capitalized? 5. The lack in understanding of which costs must versus may be expensedUnder the accounting rules, certain SaaS costs must be expensed, while other costs maybe capitalized based upon policy elections made by management. Understanding thenuances in the accounting literature can be unclear, confusing and complicated. For ex-ample, companies may capitalize an allocated amount of indirect costs related to soft-ware development, such as rent and utilities. However, the same companies must fullyexpense general and administrative expenses. As a result, companies may err on the sideof conservatism, choosing to expense these costs rather than investing time in develop-ing a SaaS capitalization policy.The impracticality in separating capitalizable SaaS expenses from other costsAs noted in the table prior, there are several types of SaaS expenses which are eligiblefor capitalization. For certain companies, the time and cost of identifying and separatingthese expenses outweighs any benefit to be received from capitalization. For example,the percent of loan interest cost attributable to the software development may be capital-ized. However, separating these costs may become impractical for certain companiesbased on the specificity required for capitalization. Companies may also find their ac-counting system is incapable of accurately identifying and separating costs, thereby cre-ating another reason not to invest time in separating these expenditures.The lack of resources to track SaaS expenditures eligible for capitalizationConsidering recent economic conditions, accounting and finance departments have beenreluctant to add head count. A lean accounting and finance department could act as a bar-rier to developing or modifying a SaaS capitalization policy, identifying such costs in theaccounting system and tracking and accounting for these expenditures. Moreover, othercompanies may not be willing to invest in the resources necessary to properly capitalizeand account for SaaS expenditures. 5 SaaS Companies: What Costs Should Be Capitalized? 6. Best Practice RecommendationsSaaS companies should continually evaluate the decision on when to capitalizeversus expense software development and other incremental costs as there areseveral short and long term implications. They should also consult with an ac-counting professional with expertise in SaaS revenue and expense recognition tofully understand the alternatives, and ultimately adopt the method they believemost closely follows the spirit of the accounting rules.A complete copy of the public company SaaS Cost CapitalizationDatabase can be obtained by answering five quick questions at:http://www.surveymonkey.com/s/SaaSCostsView a sample of the survey database on the following page.Matt Perreault is a Partner with Armanino McKenna, a Top 40 CPA and Consult-ing firm, and is a recognized subject matter expert in the areas of SaaS andsoftware revenue recognition, equity accounting and public company reportingrules. Contact Matt at mattp@amllp.com or (925) 790-2755.Ricardo D. Martinez is a Senior Manager with Armanino McKenna and has over12 years of experience conducting audit and advisory services predominantly inthe technology industry including seminconductor, software, internet and on- Armanino McKenna line educational segments. Contact Ricardo at ricardo.martinez@amllp.com or50 W. San Fernando St.(925) 790-2600 x7010Suite 600 San Jose, CA 951136www.amllp.comSaaS Companies: What Costs Should Be Capitalized?