This document discusses the results of a survey of over 75 publicly traded SaaS companies regarding their accounting policies for capitalizing software development costs and sales commissions. The survey found that in 2015, 64% of companies capitalized software development costs, compared to 70% in 2014 and 60% in 2013. Only 20% of companies surveyed in 2015 capitalized sales commissions, a decline from 21% in 2014. The document provides possible reasons for the trends observed and examples of wording used in company footnotes regarding their capitalization policies.
1. SaaS COMPANIES
WHEN TO CAPITALIZE COSTS
AN ARMANINO WHITE PAPER / authored by Matthew Perreault / coauthored by Martin Lwee
2. Our survey of more than 75 publicly traded SaaS companies includes excerpts from each company’s
software development and sales commissions accounting policy footnotes. The survey demonstrates
the disparity in practice as well as trends in the capitalization models used by SaaS companies. You
can use this information as a tool to gauge the accuracy, transparency and completeness of your
own policies and disclosures.
3. In late 2015, we updated our SaaS survey to identify
which of the more than 75 public SaaS companies
capitalize software development costs, and sales
commissions. The new revenue standard, ASC 606
(effective for public companies in 2018 and private
companies in 2019) isn’t expected to change the way
SaaS companies treat software development costs.
However, the standard does cite sales commissions
as an example of a cost that may require capitaliza-
tion. Today, entities make a policy election to ex-
pense such costs as incurred or capitalize them.
Under the new guidance, entities will capitalize
costs that relate directly to the contract, and are
expected to be recovered. In order for costs to
meet the “expected to be recovered” criterion, costs
should be reflected in the pricing on the contract
and recoverable through margin. Given that the rev-
enue standard mandates retrospective adoption, we
anticipate more SaaS companies will change policy
to defer commissions, avoiding a complex “what if
we had deferred?” calculation upon adoption of the
new standard.
With that in mind, we observed the following rates of
capitalization over our last three surveys:
To see how publicly traded SaaS companies are
handling software development and sales commis-
sions—and the rules surrounding these expenses—
we conducted a SaaS cost capitalization survey in
early 2012 and 2014.
60%
30%
70%
21%
64%
20%
2013 20132014 20142015 2015
Capitalizing Software
Development Costs
Capitalizing
Sales Commissions
All data based on corresponding year-end reports
4. CAPITALIZING SOFTWARE AND
APPLICATION DEVELOPMENT
Companies are capitalizing software and application
development costs at a slightly lower rate than last
year; the 2015 survey showed 64% of companies
are capitalizing such costs, compared to 70% in
2014, and 60% in 2013.
Why do we see some companies capitalizing these
costs while others don’t? Some probable answers
include:
1. Companies that generate a larger portion of
revenues from SW license models may be
less inclined to capitalize costs versus SaaS
subscription models. The threshold for capital-
izing development costs for software license
companies (achievement of technological fea-
sibility) is higher than SaaS vendors (reaching
the application development stage). Traditional
software license companies morphing into SaaS
companies likely are carrying forward their “ex-
pense all costs immediately” mindset.
2. Future useful life of SaaS software is short-
ening. As the SaaS model and related develop-
ment platforms mature, the underlying code is
written and replaced more rapidly, diminishing
the expected future useful life of such develop-
ment costs. With a minimal or questionable
useful life, the decision to expense immediately
becomes more justifiable.
3. SaaS companies are achieving profitability
more rapidly. With the increased focus on bot-
tom line, SaaS companies want to expense cost
now to avoid a “drag” on future earnings.
4. More in-house development. Generally, SaaS
companies tend to capitalize software develop-
ment costs originating from an external source
(e.g., through acquisition, labor from contract
developers) as it is easier to segregate than
costs incurred internally (e.g., distinguishing em-
ployee labor costs directly linked to a develop-
ment project). As more development is brought
in-house, the magnitude of expense subject to a
company’s capitalization policy declines.
The companies that choose not to capitalize
such cost either do not have a discussion in the
footnotes or use boilerplate wording like “costs
incurred subsequent to the establishment of
technological feasibility have not been signifi-
cant, and all software development costs have
been charged to research and development ex-
pense in the accompanying consolidated state-
ments of income.”
5. SALES COMMISSION COSTS
Surprisingly the percentage of companies capitaliz-
ing commissions has continued to decline; only 20%
of the surveyed companies chose to defer commis-
sions in 2015 (compared to 21% in 2014).
The trend could be due to the following:
1. The substantial time effort required to defer
these costs, then track and analyze the capital-
ized costs to ensure amortization is aligned with
the associated future revenue streams.
2. Companies may be unaware of the require-
ments outlined in the new revenue standard to
defer commission costs.
The companies that deferred commissions ex-
plained the chosen policy by stating:
“The Company believes this is the appropriate
method of accounting, as the commission costs
are so closely related to the revenues from the
subscription agreements that they should be re-
corded as an asset and charged to expense over
the same period that the subscription revenues
are recognized.”
The companies that choose to expense commis-
sions often use wording similar to:
“Sales commissions are recognized as an
expense when earned by the sales representa-
tive, generally occurring at the time the customer
order is signed.”
WHAT PORTION OF SALES COMMISSIONS
SHOULD BE CAPITALIZED?
Entities will need to exercise judgment when
determining whether costs incurred in obtaining
a contract are incremental. Bonuses and other
compensation that are based on other quantitative
or qualitative metrics (e.g., profitability, earnings
per share, performance evaluations) likely do not
meet the criteria for capitalization because they are
not directly related to obtaining a contract. Entities
also may pay commissions upon the renewal of a
contract or bonuses based on the achievement of
an individual’s sales goal or total bookings.
Other bonus programs may have escalation provi-
sions under which the bonus amount increases as
an individual meets performance targets. The new
revenue standard provides little guidance about the
types of costs that may be considered incremental
to obtaining a contract, so this determination may
be difficult for entities, particularly when such costs
relate to multiple contracts or are incurred over a
period of time.
6. LOOKING AHEAD
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 account-
ing 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.