Expert Advisory Committee
ICAI-Expert Advisory Committee
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1.47 Query:   

  Accounting for software development cost and related tax issues.

           

1. A professional managed software house has decided to go in for developing sophisticated versatile software products which would be compatible with the latest operating systems.

 

2. In frontline industries, software costs are assuming greater proportions. Use of state-of-the-art software can give such industries a fillip, especially where the business locations are geographically dispersed. All these costs are of substantial amounts apart from the hardware costs, as complete software solutions are many a time provided by stand-alone software houses like the company referred to in the query. Large software projects undertaken by end users using in-house talent require heavy expenses, and results are not always guaranteed. There is therefore huge potential for state-of-the-art guaranteed software products for computerisation at competitive costs.

 

3. One of the major hurdles faced by software houses is, however, the high cost of developing new software from scratch, and the difficulty of raising the resources for it by way of debt. The rights to use the software product developed can be sold over and over again, over a considerable time period and thus the product developed becomes a valuable asset which, however, is not reflected in the balance sheet as such. The inability to convert software development costs into an asset in their balance sheets adversely affects their ability to raise resources by way of debt. Weighed against that is the problem of paying higher taxes today if software costs are not expensed fully but capitalised and amortised over a period.

 

4. To get over these twin problems, the querist proposes to defer the software development costs and amortise the same over the estimated life-span of the products developed. For income-tax purposes, however, it proposes to claim a deduction under section 35 in the year in which they are incurred, as they are expenditure for scientific research and development related to the business of the company

 

5. The querist has stated that FASB Statement No. 86 on ‘Accounting for Costs of Computer Software to be Sold, Leased or Otherwise Marketed’, is the most relevant and particular accounting standard which is relevant for the querist’s circumstances. According to the querist, the above statement does not apply to the accounting problem of costs of in-house software for internal use or of customised software developed under a contract. This basically applies to software products. It is mandatory in the U.S. for fiscal years beginning after 15.12.85. The querist has stated that the statement lays down the following rules in brief:

 

(i) Once technological feasibility of the software project is established, the costs incurred to produce product masters shall be capitalised. These costs include cost of coding, testing, etc. done after feasibility has been established, and all costs incurred up to the time the product is available for general release to customers. Costs of duplicating the software documentation and training materials and physical packing of the product should be treated as inventory and the cost and revenue recognised when particular units are sold, on per unit basis.

 

(ii) Capitalised costs should be amortised on product-by-product basis. The annual amortisation will be greater of

 

(a) The ratio that current gross revenue bears to the expected future total revenues, and

 

(b) Straight line method over the period of estimated economic life of the software product.

 

6. The querist has also stated that Accounting Standard (AS) 8 on ‘Accounting for Research and Development’, issued by the Institute of Chartered Accountants of India, lays down the following norms:

 

(i) Research and development costs of a project may be deferred, if following criteria are satisfied:

 

(a) Product or process is clearly defined and costs attributable to it can be separately identified;

 

(b) Its technical feasibility has been demonstrated;

 

(c) The management has indicated its intention to produce or market it;

 

(d) There is a reasonable indication of the future revenues/benefits exceeding R & D costs together with expected production, selling and administration costs; and

 

(e) Adequate resources exist or are reasonably expected to be available, to complete the project and market the product or process. [para 9]

 

(ii) Where costs are deferred, legal requirements should be considered. [para 10]

 

(iii) Where a policy of deferral of research and development expenses is adopted, it should be applied to all projects satisfying the criteria specified in para 9. [para 11]

 

(iv) Deferred costs should be allocated to future periods on the basis of sale or use of the products or the time period over which the product is sold or used. [para 12]

 

(v) Deferred expenditure should be separately disclosed in the Balance Sheet under the head “Miscellaneous Expenditure”. [para 16]

 

7. The querist has also stated that International Accounting Standard (IAS) 9 on ‘Accounting for Research and Development Activities’, lays down the criteria for deferral of research and development expenses which are the same as those specified by AS 8. [para 17 of IAS 9]. According to the querist, the basis of deferral and the disclosure requirements are also the same as those specified by AS 8 [paras 20 and 24 of IAS 9].

 

8. The querist has informed that the Exposure Draft 32 on ‘Comparability of Financial Statements’, which proposed to amend IAS 9 has proposed to permit the following treatment as ‘Allowed alternative treatment’:

 

“Development costs that satisfy the criteria in paragraph 17 may be recognised as an asset provided the information required by paragraph 18A of the International Accounting Standard 5, information to be disclosed in Financial Statements, is disclosed.” [proposed para 16A] (refer, The Chartered Accountant, June, 1989)

 

However, after the Exposure Draft 32 was issued , there has been a world wide rethinking on this matter which has culminated in the International Accounting Standard Committee issuing a ‘Statement of Intent: Comparability of Financial Statements’, wherein it has made the following proposal:

 

“Recognition of development costs

 

Required treatment- development costs should be recognised as an asset when they meet the criteria in paragraph 17 of IAS 9 and it is probable that these costs will be recovered. Such costs should be allocated on a systematic basis to future periods in accordance with paragraph 20 of IAS 9.

 

Eliminated treatment – the Exposure Draft will propose that development costs which meet the criteria in paragraph 17 of IAS 9 should not be charged as an expense in the period in which they are incurred”

 

(refer, The Chartered Accountant, September 1990)

 

9. According to the querist, software costs are mostly salary and overhead costs. However, for more clear understanding of the process of software construction, it would be illuminating to see the stages that software construction goes through. Mr. Robert McGee, Manager of Accounting Practicies in New York’s National Association of Accountants, in his book ‘Accounting for Software’ breaks down software construction costs into six categories (chronological phases):

 

a. Feasibility costs, and other costs incurred prior to design costs in the software product life cycle.

 

b. Design costs.

 

c. Coding costs.

 

d. Testing costs.

 

e. Support costs.

 

f. Service costs.

 

10. In the light of the above, the querist states that all the major Accounting Standards are in favour of capitalising software development costs provided the five norms specified in para 9 of AS 8 or those of para 17 of IAS 9 are met.

 

11. The querist’s case under review satisfies the above-mentioned criteria as follows:

 

(i) The software package is a distinct product. It is being developed at a separate Product Development Centre and hence, its costs can be separately identified.

 

(ii) The product is technically feasible as it is based on software/programming languages which are used world-wide and is not based on a totally new system. The feasibility of the package is also demonstrated by the market response indicated by an informal survey conducted among its clients.

 

(iii) The investment made in the project and the market survey carried out clearly indicate the intention of the management to produce and market the software package. The intent has also been made known to the company’s bankers for the purpose of raising a loan.

 

(iv) The packages will have a very long economic life and can be upgraded with little modification so that risk of obsolescence is minimised.

 

(v) The resources to complete the project and market the package are expected to be available on account of the loans being raised.

 

  12. The querist has contemplated the following accounting treatment:

 

(a) Revenue costs on software development will be accumulated and treated as Miscellaneous Expenditure and will be disclosed in the balance sheet under the head “Miscellaneous Expenditure (to the extent not written off or adjusted)” as Development Expenditure.

 

(b) Miscellaneous expenditure will be amortised based either on per product sale basis or on sales volume p.a., the actual amount of amortisation depending on an educated estimated resulting from an analysis of the market for the product and an annual review of the same. In the first case, the annual amortisation will be the ratio that the units sold during the year bears to the expected total future unit sales. Where the alternative treatment is adopted, the amount amortised would be the ratio that current gross revenue bears to the expected total future revenue.

 

(c) Capital costs which result in the creation of intangible assets will be treated in the same manner as revenue costs.

 

(d) Capital costs resulting in the acquisition of tangible assets will be capitalised under the head ‘Fixed Assets’ under appropriate sub-heads as per Schedule VI to the Companies Act, 1956. Depreciation thereon will be provided as per Schedule XIV to the said Act.

 

(e) Suitable disclosure regarding software development expenses, both revenue and capital, will be made in the annexure to the Directors’ Report as required by the Companies (Disclosure of Particulars in the Report of Board of Directors) Rules, 1988.

 

(f) For income-tax purposes, however, the full amount of the capital expenditure on tangible and intangible assets acquired/created will be written off in the first year itself under section 35(1)(iv) read with section 35(2)(ia) of the Income-tax Act, 1961.

 

 13. In the context of the facts and principles outlined above, the querist seeks the opinion of the Expert Advisory Committee on whether the contemplated accounting treatment is in conformity with acceptable accounting principles and is sufficient compliance with the Companies Act, 1956. If not, what in the Committee’s opinion is the most appropriate accounting treatment for the company referred to in the query? It would be also enlightening if an indication is made regarding the nature of documentation and evidences necessary to effectuate the above plan.

 

                                                                      Opinion                                   February 11, 1991

 

1. The Committee notes paragraphs 7 to 16 of Accounting Standard (AS) 8 on Accounting for Research and Development issued by the Institute of Chartered Accountants of India, which state as under:

 

                        “7.      Research and development costs should include:

           

(i) Salaries, wages and other related costs of personnel engaged in research and development;

 

(ii) Costs of materials and services consumed in research and development;

 

(iii) Depreciation of building, equipment and facilities which have alternative economic use, to the extent that they are used for research and development;

 

(iv) An appropriate amortisation of the cost of building, equipment and facilities which have no alternative economic use, to the extent that they are used for research and development;

 

(v) Overhead costs related to research and development;

 

(vi) Payment to outside bodies for research and development projects related to the enterprise; and

 

(vii) Other costs related to research and development such as amortisation of patents and licences.

 

8. Amount of research and development cost described in paragraph 7 should be charged as an expense of the period in which they are incurred except where such costs may be deferred in accordance with paragraph 9.

 

9. Research and development costs of a project may be deferred to future periods, if the following criteria are satisfied:

 

(i) The product or process is clearly defined and the costs attributable to the product or process can be separately identified;

 

(ii) The technical feasibility of the product or process has been demonstrated;

 

(iii) The management of the enterprise has indicated its intention to produce and market, or use, the product or process;

 

(iv) There is a reasonable indication that current and future research and development costs to be incurred on the project together with expected production, selling and administration costs are likely to be more than covered by related future revenues/benefits; and

 

(v) Adequate resources exist, or are reasonably expected to be available, to complete the project and market the product or process.

 

10. Wherever research and development costs are deferred, the appropriate legal requirements should also be taken into account.

 

11. If an accounting policy of deferral of research and development costs is adopted, it should be applied to all such projects that meet the criteria in paragraph 9.

 

12. If research and development costs of project are deferred, they should be allocated on a systematic basis to future accounting periods by reference either to the sale or use of the product or process or to the time period over which the product or process is expected to be sold or used.

 

13. The deferred research and development costs of a project should be reviewed at the end of each accounting period. When the criteria of paragraph 9, which previously justified the deferral of the costs, no longer apply, the unamortised balance should be charged as an expense immediately. When the criteria for deferral continue to be met but the amount of unamortised balance of the deferred research and development costs and other relevant costs exceed the expected future revenues/benefits related thereto, such expenses should be charged as an expense immediately.

 

14. Research and development costs once written off should not be reinstated even though the uncertainties which had led to their being written off no longer exist.

 

Disclosure

 

15. The total of research and development costs, including the amortised portion of deferred costs, charged as expense should be disclosed in the Profit & Loss Account for the period.

 

16. Deferred research and development expenditure should be separately disclosed in the Balance Sheet under the head ‘Miscellaneous Expenditure’.

 

2. The Committee further notes that para 16.3 and 37 of Accounting Standard (AS) 10 on ‘Accounting for Fixed Assets’, state as follows:

 

“16.3 Patents are normally acquired in two ways: (i) by purchase, in which case patents are valued at the purchase cost including incidental expenses, stamp duty, etc. and (ii) by development within the enterprise, in which case identifiable costs incurred in developing the patents are capitalised. Patents are normally written off over their legal term of validity or over their working life, whichever is shorter.

 

37. The direct costs incurred in developing the patents should be capitalised and written off over their legal term of validity or over their working life, whichever is shorter.”

 

  3. The Committee also notes section 35 of the Income-tax Act, 1961 which states inter alia:

 

                        “Expenditure on scientific research.

                       

                 35 (1) In respect of expenditure on scientific research, the following deductions shall be allowed –

                

                  (i) Any expenditure (not being in the nature of capital expenditure) laid out or expended on scientific research related to the business.

 

Explanation: Where any such expenditure has been laid out or expended before the commencement of the business (not being expenditure laid out or expended before the 1st April, 1973) on payment of any salary (as defined in Explanation 2 below sub-section (5) of section 40A) to an employee engaged in such scientific research, the aggregate of the expenditure so laid out or expended within the three years immediately preceding the commencement of the business shall, to the extent it is certified by the prescribed authority to have been laid out or expended on such scientific research, be deemed to have been laid out or expended in the previous year in which the business is commenced;…………………………………..

 

(iv) In respect of any expenditure of a capital nature on scientific research related to the business carried on by the assessee, such deduction as may be admissible under the provisions of sub-section (2)…………..

 

(2)         For the purposes of clause (iv) of sub-section (1), -

 

(i) In a case where such capital expenditure is incurred before the 1st day of April, 1967, one-fifth of the capital expenditure incurred in any previous year shall be deducted for that previous year; and the balance of the expenditure shall be deducted in equal instalments for each of the four immediately succeeding previous years;

 

(ia) In a case where such capital expenditure is incurred after the 31st day of March, 1967, the whole of such capital expenditure incurred in any previous year shall be deducted for that previous year:

 

Provided that no deduction shall be admissible under this clause in respect of any expenditure incurred on the acquisition of any land, whether the land is acquired as such or as part of any property, after the 29th day of February, 1984.

 

Explanation 1: Where any capital expenditure has been incurred before the commencement of the business, the aggregate of the expenditure so incurred within the three years immediately preceding the commencement of the business shall be deemed to have been incurred in the previous year in which the business is commenced.”

 

4. The Committee is of the view that the research and development costs which are revenue in nature and are related to the development of a software should be expensed in the period in which they are incurred if the conditions referred to in paragraph 9 of AS 8 are not met. In case the conditions referred in paragraph 9 are met, these costs may be deferred and disclosed in the balance sheet under the head “Miscellaneous Expenditure”. The Committee is also of the view that on the date the software is commercially ready to be sold, leased or otherwise marketed, and the software becomes the copyright of the organisation, the deferred research and development costs incurred and accumulated till that date should be capitalised and shown under the head fixed assets just like ‘patents’. Once the above costs are capitalised, they should be amortised on a systematic basis as suggested in paragraph 12 of AS 8.

 

5. The Committee is also of the view that the expenditure related to the development of software which result in acquisition or creation of tangible or intangible assets should be capitalised and shown under the fixed assets.

 

6. The Committee is also of the view that for income-tax purposes all expenditure, whether revenue or capital in nature, related to the development of software is allowed as deduction in the year in which it is incurred. The deduction of capital expenditure is subject to the provisions of sub-section (2) of section 35 of the Income-tax Act.

 

  7. The Committee is of the following opinion in respect of accounting treatment contemplated by the querist in paragraph 12 of the query:

 

(a) Revenue costs on software development can be deferred if the conditions specified in paragraph 9 of the AS 8 are met and disclosed in the balance sheet under the head “Miscellaneous Expenditure”.

 

(b) When the software is commercially ready for being sold, leased or otherwise marketed, and the software becomes the copyright of the organisation, the revenue costs deferred under (a) above should be capitalised under the head fixed assets. After the capitalisation, the capitalised cost should be allocated on a systematic basis to future accounting periods by reference either to sale or to the time over which the software is expected to be sold or used.

 

(c) Capital costs incurred for creation of intangible assets such as patents, trade marks and designs should be shown under the head fixed assets under appropriate heads.

 

(d) The treatment and disclosure suggested in para 12(d) and (e) is correct.

 

(e) For income tax purposes, the capital expenditure, on development of software can be claimed as deduction subject to the provisions of sub-section (2) of section 35 of the Income-tax Act.

 

8. The Committee is also of the opinion that nature of documentation and evidences required in respect of accounting for software development costs will depend upon facts and circumstances of each case. In case the research and development costs are deferred, documents should be kept which justify the fulfillment of the conditions laid down in paragraph 9 of AS 8. These documents can be market survey reports, technical feasibility report, financial arrangements, etc.

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