Navigating the Accounting maze: Internally developed software under IFRS

Introduction:

In the digital age, businesses are increasingly reliant on software solutions to drive innovation and streamline operations. The development of internally developed software (IDS) is a strategic endeavour that offers immense potential but also presents complex accounting challenges. An entity can develop a software for its own use or for slae or for licencing. Further, the cost incurred may be external cost or Internal cost i.e Salaries paid to its employees. International Financial Reporting Standards (IFRS) provides a framework for accounting treatment, laying out conditions that need to be satisfied. In this article, we delve into the conditions, practical challenges an entity may face while accounting the cost incurred towards development of the software and the safeguards that can be built into the process by an organisation to confidently face any scrutiny by auditor or any other regulatory authorities.

Accounting for cost incurred towards development of software

The first step is to check whether the following points can be demonstrated:

(i)???Does the software under development meets the definition of Intangible asset given in IAS 38.

(ii)??Does the software under development meets the recognition criteria provided in IAS 38

Components of definition of Intangible asset

If we look at the definition of Intangible asset it can be said that it consist of following three components and criteria that should be satisfied to say that asset meets the definition of Intangible asset:

i.???Identifiability

The asset under development should be separately identifiable. An asset is identifiable if is capable of being separated from the entity and sold, transferred. Licensed, rented, or exchanged. It is not relevant whether the entity intended to transfer the asset.

ii.??Control

An entity should be able to control the usage of the asset. That means the entity has the power to obtain future economic benefits that will flow from the underlying resources / asset and to restrict the access to others to those benefits.

iii.?Future economic benefits

An entity should be able to establish that there will be economic benefits which will flow to it by way of? revenue or saving of future cost.

?Recognition criteria

An entity will recognise an asset only if:

i.???It is probable that the expected future economic benefits that are attributable to the asset will flow to the entity.

ii.???The cost of the asset can be measured reliably.

The next step is to assess phase of software development. For the purpose of deciding the accounting of cost incurred, development of a software can be divided in to two phases:

1.???? Research phase

2.???? Development phase

Always the cost incurred in research phase should be expensed as and when incurred.

The cost incurred in development phase can be capitalised, if and only if, it satisfies all the requirements set out in IAS 38-Intangible asset.

An entity can capitalise the cost incurred in the development phase, if it establishes all of the following:

(Para 57 of IAS 38)

i.???The technical feasibility of completing the intangible asset so that it will be available for use or sale.

ii.??Its intention to complete the intangible asset

iii.??Its ability to use or sell the Intangible asset

iv.??How the intangible asset will generate probable future economic benefits.

v.???The availability of adequate technical, financial and other resources to complete the development and to use or sell the intangible asset.

vi.??Its ability to measure reliably the expenditure attributable to the intangible asset during its development.

However, out of the above 6 conditions most of the organisations face difficulty in complying with establishing probable economic benefits and measuring attributable cost. An organisation should plan well to full fill these two conditions and maintain robust documentation which will help it to demonstrate the asset under consideration fulfils the conditions to be capitalised.

To measure the future economic benefits for the purpose of capitalisation, taking the following steps and documenting it will help the organisations:

1.???? Identifying Future Economic Benefits: The first step is to identify the potential future economic benefits that are expected to flow to the entity from the use or sale of the intangible asset. These benefits could come in the form of increased revenues, reduced costs, or other potential advantages that the asset provides.

2.???? Estimating Future Cash Flows: Once the potential economic benefits are identified, the entity needs to estimate the future cash flows that will result from the asset's use or sale. This involves making reasonable and supportable projections based on historical data, market trends, and other relevant factors.

3.???? Consideration of Risk and Uncertainty: The estimation of future cash flows should take into account any risks and uncertainties associated with the asset. This might involve considering factors like changes in market demand, technological advancements, competition, and regulatory changes.

4.???? Discounting Future Cash Flows: To bring the future cash flows back to their present value, a discount rate is applied. The discount rate accounts for the time value of money and the risk associated with the asset. The discount rate is often based on the entity's cost of capital or another suitable rate that reflects the asset's risk profile.

5.???? Comparative Analysis: In some cases, a comparative analysis might be used. This involves comparing the potential economic benefits of the intangible asset to similar assets in the market or within the company.

6.???? Review and Update: The estimates of future economic benefits, cash flows, and discount rates should be reviewed and updated regularly to reflect changes in market conditions, technology, and other relevant factors.

However, It's important to note that the measurement of future economic benefits for intangible assets requires judgment and may involve complexities, especially when dealing with unique or novel assets. The aim is to ensure that the capitalized value of the intangible asset accurately represents its economic value to the entity.

Measurement of cost

The cost of an Internally developed software may include Internal cost or external cost. For Internal cost an organisation may think of creating projects and tracking the time spent by its employee on specific project. External costs are easy to track in the form purchase orders issued to the vendors, Invoices etc. Only those cost which are attributable for development of software can be capitalised.

How an organisation can avoid some of the issues which may be faced while capitalising Internally developed software:

An organisation can look at the following action items to avoid any of the issues arsing or defend its capitalisation of Internally developed software:

1.???? Clear Capitalization Policy:

Establish a clear and comprehensive policy outlining the criteria that software projects must meet to be capitalized. This policy should define the stages of development that qualify for capitalization, such as the development phase versus the maintenance phase.

2.???? Project Approval Process:

Implement a structured process for approving software projects for capitalization. This process should involve key stakeholders, such as finance, IT, and project management, to ensure alignment with the capitalization policy.

3.???? Documentation and Tracking:

Maintain detailed documentation of the development process, including project plans, design documents, coding standards, and progress reports. Use project management tools to track milestones and development stages.

4.???? Cost Allocation:

Clearly allocate costs associated with the development of the software, including labour, overhead, and other expenses. Ensure that the allocation method aligns with generally accepted accounting principles.

5.???? Time Tracking:

Implement a system for accurately tracking the time spent by employees on software development activities. This helps in determining the capitalizable labour costs.

6.???? Internal Audit:

Regularly conduct internal audits of software development projects to ensure compliance with the capitalization policy and proper documentation of costs and progress.

7.???? Segregation of Duties:

Separate responsibilities among individuals involved in the project to prevent conflicts of interest. For instance, the same person who develops the software should not be solely responsible for deciding whether to capitalize it.

8.???? Independent Review:

Introduce an independent review process where a designated team evaluates the project's compliance with the capitalization policy before final approval.

9.???? External Expertise:

Engage external experts, such as auditors or consultants, to assess and validate the capitalization process and ensure it aligns with accounting standards.

10.? Regular Training:

Provide ongoing training to employees involved in software development about the capitalization policy, the importance of accurate documentation, and compliance requirements.

11.? Monitoring and Reporting:

Establish regular reporting mechanisms to track the status of capitalized software projects, including the amount of capitalized costs, ongoing maintenance costs, and any changes to the project's capitalization status.

12.? Reassessment:

Periodically reassess capitalized software projects to ensure they still meet the capitalization criteria. If a project no longer qualifies, ensure proper reclassification and adjustment of financial records.

Accounting for internally generated software under IFRS is a nuanced endeavour, demanding adherence to specific conditions. The practical challenges that company face in satisfying these conditions highlight the complexity of software development. To navigate this terrain successfully, businesses need not only robust accounting expertise but also a deep understanding of their software development lifecycle. The digital landscape is constantly evolving, and with it, the challenges associated with accounting for internally generated software. As companies continue to innovate and create value through software solutions, staying well-versed in the accounting intricacies becomes paramount for accurate financial reporting and informed decision-making.

?Reference: IAS 38: Intangible Asset

???????????????????? Manual of IFRS (PWC)