Armanino McKenna conducted a survey of 47 public SaaS companies to examine their accounting policies for certain expenses. The results showed 70% of those SaaS companies are capitalizing expenses - the two most common expenses capitalized are software development expenses and sales commissions. To understand the diversity in capitalization practices, we examined the rules for capitalizing these and other SaaS expenses.

1. SaaS
Companies
What Costs
Should Be
Capitalized?
Introduction
An 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 customer
are obvious—reduced capital expenditures and IT support costs.) Although
SaaS 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. Armanino
McKenna conducted a survey of 47 public SaaS companies to examine
their accounting policies for certain expenses. The results showed 70% of
those SaaS companies are capitalizing expenses - the two most common
expenses 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.
1
FASB ASC Subtopic 605-25, Revenue Recognition – Multiple-Element Arrangements
1
SaaS Companies: What Costs Should Be Capitalized?

2. SaaS Expenditures/Capitalization Costs
The 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 SaaS
expenditures associated with the development and maintenance of software and/or website applications.
Portion of Expenditures
Type of Software Development Expenses Portion to Expense
Eligible for Capitalization
Salaries and employee benefits for software and
1 After technological feasibility2 or appli-
website developers/engineers
cation development stage3 but before
Internal use software and related costs, such as general release
2 developing or obtaining software that allows for Costs incurred to establish
access to or conversion of old data by new system technological feasibility4
NOTE: Upgrades/enhancements, (i.e., purchased software,
Fees paid to outside providers for software including those related to a website, application, and/or website
3 must be probable of providing addi-
development planning costs) and costs in-
tional functionality curred after general release
4 Develop website graphics
(i.e., release of bug fixes,
Interest costs associated with loans used to fund patches, inputting website
Percent attributable to development
5 software development or purchase software content, website data con-
meeting capitalization criteria
under a capital lease version, registering with an
An allocated amount related to soft- internet search engine, etc.)
Indirect costs--overhead facilities (i.e., rent, ware development after technological
6
utilities, etc.) feasibility or application development
stage but before general release
7 Website-obtain and register internet domain All costs capitalized as other intangibles Not applicable
8 General and administrative department costs
9 Training-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) installation
11 assistance, 3) telephony support, 4) newsletters, Not applicable As 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 a
12
new territory or with a new class of customers, or
3) commencing some new operation
Website hosting, such as monthly fees paid to
13
co-location providers
Purchased software with alternative
Purchased software with
future use (i.e., for use in developing
no alternative future use
14 Purchased software software for direct resale or developing
accounted for as internal use
a website) with amortization over the
software5
expected period of use
2
Under 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 testing
activities that are necessary to establish that the product can meet its designed functions, features, and technical performance requirements.
3
ASC 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 or
explicitly authorizes and commits to funding and completing a computer software project
4
Expense as research and development in accordance with ASC 730-10, Research and Development-Overall
5
Under ASC 985-20-25, such software costs would only be capitalizable during the application development stage and prior to general release
2
SaaS 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) the
straight-line method over the remaining estimated useful life. Capitalized costs related to internal use
software are generally amortized on a straight-line basis. Product enhancements are generally amortized
on a straight-line basis over the useful life of the enhancement. Software development costs are typi-
cally categorized as research and development expenses.
Incremental Expenses
The table below highlights incremental expenses incurred outside of the development process.
Portion of Expenditures
Type of Service Expenses Portion to Expense
Eligible for Capitalization
As incurred is always accept-
Commissions can be deferred and amortized able for such costs. The policy
to sales expense over the term of the related should be selected based on
subscription period as long as the commission is an analysis of the arrange-
1 Internal and external sales commission
paid only for successful efforts and the agree- ments and the costs incurred,
ment contains a clawback provision the company rather than on a goal of
intends to enforce. capitalizing (or expensing) a
certain amount of costs.
Costs of acquiring contracts, includ-
ing 1) due diligence activities after
competitive selection, 2) evaluation of
2
customers credit rating and 3) prepara- Both practice and SEC staff accept capitalization
tion and processing documentation of of incremental direct set-up and similar costs
the transaction incurred after a contract is obtained, amortizing Not applicable
Post-contract set-up costs, including on a straight-line basis over the service/contract
1) setting up customer accounts, 2) term6
3 installation of systems and processes to
support the acquired contract, and 3)
accumulating and converting data
As incurred if professional
Defer when professional services revenue cannot
Costs of delivering professional services services revenue can be
4 be separately recognized, amortizing over the
related to subscription agreements recognized separately from
same period as professional service revenue 7
subscription revenues7
Expensing all advertising
costs is an acceptable alterna-
tive policy to deferral
May select a policy to defer and expense upon
5 Advertising the first time advertising takes place (i.e., first
NOTE: Accounting policy must
showing/ 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 licenses
6 ments expensed as reported
royalty fee 2. Perpetual licenses
to licensor
6
ASC 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 as
outlined in ASC 310-20-35, Receivables-Nonrefundable Fees and Other Costs, and warranty/maintenance contracts as outlined in ASC 605-20-25, Revenue-Services
7
Under 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 the
services themselves; and 2) there is evidence of the fair value of the services (i.e., price when sold separately)
3
SaaS Companies: What Costs Should Be Capitalized?

4. Lack of Capitalizing Expenses Reasoning
Like 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 costs
only to the extent of deferred revenues. This policy is less preferable than one that adopts
a full cost deferral model or expenses all costs as incurred. However, a policy of deferring
direct costs to the extent of deferred revenues is acceptable, if applied consistently. Re-
gardless of the decision to capitalize or expense, companies should appropriately disclose
their choice of accounting policy.
Considering 70% of surveyed companies are capitalizing costs, a question arises as to why
more companies are not taking advantage of the capitalization rules. We’ve determined the
lack of capitalizing SaaS expenses can be attributed, in part, to the following:
A short period between technological feasibility (or application development stage)
and general release
Lower cost, more powerful development tools have created low barriers to entry, result-
ing in intense competition, accelerating the pace of application development, shortening
the time frame between technological feasibility and release. This period can be so brief
that any costs eligible for capitalization are nominal. Additionally, the rapidly changing
application 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 expensed
Under the accounting rules, certain SaaS costs must be expensed, while other costs may
be capitalized based upon policy elections made by management. Understanding the
nuances 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 fully
expense general and administrative expenses. As a result, companies may err on the side
of 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 costs
As noted in the table prior, there are several types of SaaS expenses which are eligible
for capitalization. For certain companies, the time and cost of identifying and separating
these 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 companies
based 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 capitalization
Considering recent economic conditions, accounting and finance departments have been
reluctant 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 the
accounting system and tracking and accounting for these expenditures. Moreover, other
companies may not be willing to invest in the resources necessary to properly capitalize
and account for SaaS expenditures.
5
SaaS Companies: What Costs Should Be Capitalized?

6. Best Practice Recommendations
SaaS companies should continually evaluate the decision on when to capitalize
versus expense software development and other incremental costs as there are
several short and long term implications. They should also consult with an ac-
counting professional with expertise in SaaS revenue and expense recognition to
fully understand the alternatives, and ultimately adopt the method they believe
most closely follows the spirit of the accounting rules.
A complete copy of the public company SaaS Cost Capitalization
Database can be obtained by answering five quick questions at:
http://www.surveymonkey.com/s/SaaSCosts
View 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 and
software revenue recognition, equity accounting and public company reporting
rules. Contact Matt at mattp@amllp.com or (925) 790-2755.
Ricardo D. Martinez is a Senior Manager with Armanino McKenna and has over
12 years of experience conducting audit and advisory services predominantly in
the technology industry including seminconductor, software, internet and on-
Armanino McKenna line educational segments. Contact Ricardo at ricardo.martinez@amllp.com or
50 W. San Fernando St. (925) 790-2600 x7010
Suite 600
San Jose, CA 95113 6
www.amllp.com SaaS Companies: What Costs Should Be Capitalized?