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Friday, October 21, 2016

SaaS Companies: When to Capitalize Costs


Our 2016 survey of 90 publicly traded software-as-a-service (SaaS) companies includes excerpts from each company’s software development and sales commission accounting policy footnotes. The survey shows both the trends and the disparity in practice 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.

Our annual SaaS cost capitalization survey examines the capitalization practices of publicly traded SaaS companies, to determine the extent to which sales commissions and development costs are being capitalized. The 2016 survey is our largest yet and includes 89 public SaaS companies ― up from 80 last year ― audited by 15 different CPA firms.

There are 11 newcomers on the survey list (Box, Castlight Health, Determine, Five9, HubSpot, New Relic, Opower, Q2 Holdings, Xero and Zendesk), while Constant Contact and Yodlee were removed as both were acquired in 2015.

There are 11 newcomers on the survey list (Box, Castlight Health, Determine, Five9, HubSpot, New Relic, Opower, Q2 Holdings, Xero and Zendesk), while Constant Contact and Yodlee were removed as both were acquired in 2015.

We found the following rates of capitalization in this year’s survey and our previous three years:

Capitalizing Sales Commissions
Capitalizing Sales Commissions
Capitalizing Software Development Costs
Software Development Costs
All data based on corresponding year-end report

CAPITALIZING SALES COMMISSION COSTS

The percentage of companies capitalizing commissions increased this year to 25%, reversing a surprising decline in 2015. This uptick indicates a positive trend toward better preparation by companies, which will mean a smoother transition to the new revenue guidelines:

How ASC 606 affects commission costs

The new revenue recognition standard mandates that companies capitalize sales commissions if such costs are expected to be recovered through future revenues, unless the amortization period is one year or less. The capitalization of costs incremental to obtaining a contract and determining the period of amortization will be one of the most significant areas affected by the new revenue recognition standard, as companies will no longer have the option to immediately “expense as you go.”

Although the current GAAP standard requires companies to capitalize development costs, it permits them to make a policy election on capitalizing sales commissions. The new standard does provide a practical expedient that appliesprincipally to SaaS contracts of less than one year, but with the majority of SaaS sales teams focused on multiyear deals, we expect that most companies will move to capitalizing commissions when they adopt ASC 606.

The new revenue standard also mandates retrospective adoption, requiring companies to disclose “what if” they had adopted these accounting practices in prior periods. This year’s 5 percentage point increase in companies capitalizing commissions (25% in 2016 versus 20% in 2015) is likely a result of companies choosing to change their accounting policy in anticipation of future adoption to avoid restating prior-year commissions when they adopt ASC 606. Interestingly, two existing participants (Citrix and Medidata Solutions) disclosed a policy for deferring sales commissions for the first time, while a meaningfully higher percentage of the newcomers (36%) elected to capitalize sales commissions.

Applying the new standard

Upon adoption, management should assess the recoverability of incremental costs on a contact-by-contract basis and consider multiple factors, including historical experience with similar contracts, variable considerations such as discounts, and potential renewals or follow-on contracts. The recognized asset should be amortized on a systematic basis consistent with the transfer to the customer of the goods or services to which the asset relates (ASC 340-40-35-1). In certain instances, the recognized asset will be amortized over a period of benefit that may be longer than the contract, if the contract includes a renewal option that is expected to be exercised without any incremental expense for each renewal period.

Beyond the basics, there are many additional factors that companies must consider when applying the new revenue standard. For example, should bonus payments made to sales managers for achieving certain sales targets be considered incremental costs, when the bonus itself is not incremental to any one contract?

The effective date for the new guidelines is fast approaching. We recommend that companies reevaluate their commission policies now, in light of the new rules that may accelerate the timing of revenue recognition, and track the sales commission expense for multi-year contracts that span across the adoption date from prior periods.


CAPITALIZING DEVELOPMENT COSTS

There are still significant differences in the way SaaS companies capitalize development costs. Surprisingly, 9 of the 10 survey newcomers (90%) have adopted the policy of capitalizing these costs, bucking the overall trend.

Practices vary widely among firms using license models

Companies that sell software using a license model provide a useful comparison. These firms are subject to ASC 985- 20, which requires that they begin capitalizing development costs once they achieve technological feasibility, and stop capitalizing such costs when the product is available for release. These guidelines provide management with a great deal of flexibility in determining “technological feasibility” and amortization parameters.

Despite this GAAP requirement, the practice of capitalizing such costs varies widely and has largely been a matter of subjectivity. Public company practice and the lack of SEC enforcement on this topic indicate that software companies view the capitalization of software development costs as a policy election, rather than a mandate. Companies pour significant time and resources into software development, so the differing treatment of these costs has a significant impact on their reported financial performance and distorts comparability across companies in the industry.

We did a survey a few years ago that showed that 70% of software companies using a license model were not capitalizing development costs, with most providing a disclosure such as: “The period of time between technological feasibility and release is so short that such costs were not material.” These companies likely take the position that technological feasibility is established at the same time the software product can be used.

Fewer SaaS firms are capitalizing these costs

SaaS companies are subject to different GAAP rules (ASC 350-40 and 720-45) governing the capitalization of development costs. These rules mandate that preliminary project costs be expensed, but when the project plan is finalized and application development begins, these costs must be capitalized.

Our 2016 survey results indicate that 40% of SaaS companies treat capitalizing these costs as a policy election. Their statements are similar to their software peers who don’t capitalize such costs; one analogous disclosure said: “There were no material qualifying costs incurred during the application development stage in any of the periods presented.”

’s hard to believe that 39% of the SaaS companies surveyed don’t spend material amounts on application development, yet remain competitive. This move away from capitalization (61% in 2016 versus 68% in 2015) is partially supported by the industry’s shift toward software development techniques such as rapid prototyping, whereby coding and design occur simultaneously. The reluctance to capitalize development costs may also be attributed to other factors, like the operational burden of tracking and organizing expenses and installing appropriate cutoff measures between the various stages of development. There is also downside risk related to the future write-down of previously capitalized development costs, which may create unnecessary earnings surprises.

Auditors may influence capitalization rates

A closer look at the numbers by auditor shows that SaaS companies using certain audit firms, including Grant Thornton (100%) and Deloitte (85%), capitalize development at a much higher rate than those using other comparable firms, such as EY (48%) and BDO (0%). This indicates that the decision to capitalize development costs may be indirectly influenced by the opinion of the auditor and their level of scrutiny over the capitalized development expense.


LOOKING AHEAD

SaaS companies should continually evaluate their decision on when to capitalize versus expense development, commissions and other incremental costs, as there are numerous short- and long-term implications. They should also consult with an accounting 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.


Download the white paper below to get a complete copy of the public company SaaS Cost Capitalization Database.


STRATEGIC INSIGHTS - PRACTICAL ACTION

Armanino provides an integrated set of accounting services — audit, tax, consulting and technology solutions — to a wide range of organizations operating both in the U.S. and globally.

You can count on Armanino to think strategically and provide the sound insights that lead to positive action. We address not just your compliance issues, but your underlying business challenges, as well —assessing opportunities, weighing risks, and exploring the practical implications of both your short- and long-term decisions.

When you work with us, we give you options that are fully aligned with your business strategy. If you need to do more with less, we will implement the technology to automate your business processes. If the issue is financial, we can show you proven benchmarks and best practices that can add value companywide. If it’s operational, we’ll consult with your people about workflow efficiencies. If it is compliance, we’ll ensure that you meet the requirements and proactively plan to take full advantage of the changes at hand. At every stage in your company’s lifecycle, we’ll help you find the right balance of people, processes and technology.



Matthew Perreault, CPA – Partner, Audit

Joe Chung, CPA – Senior Manager, Audit

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