How Deferring and Amortizing Development Costs Impacts a Software Company’s Financial Statements
Capitalized Contract Costs
Your engineering team just spent $110,000 with a third-party development partner building features for a new SaaS contract. The features are specific to this customer’s requirements, but they also create capabilities that will serve future contracts on the same platform.
Under ASC 340-40 and ASC 606, those same costs are likely required to be recorded on your balance sheet as contract assets, deferred and amortized over the life of the contract they support.
How Incremental Costs Should be Recorded
Subtopic 340-40 establishes the accounting for incremental costs of obtaining a contract and costs to fulfill a contract. For software companies, when revenues are recognized over a period of time, the accompanying contract costs are expensed over the same period of time.
Costs to fulfill a contract are capitalized as contract assets when three conditions are met:
- The costs relate directly to a contract or anticipated contract.
- The costs generate or enhance resources that will be used to satisfy performance obligations in the future.
- The costs are expected to be recovered through the contract.
When all three conditions are met, the costs are deferred and amortized on a systematic basis consistent with the pattern of revenue recognition for the related performance obligations. The result is an income statement and balance sheet that move in sync with the contracts that drive your business.
Contract Assets vs. Internally Developed Software
Software companies face a meaningful classification determination: should pre-go-live development costs be capitalized as contract assets under ASC 340-40, or as internally developed software under ASC 350-40?
The distinction matters because amortization periods and methods may differ. Contract assets are generally amortized over the contract term. Internally developed software is amortized over its estimated useful life.
When the features being developed serve a specific contract, and future applicability to other contracts is not yet discernible, classification as contract assets is appropriate. The costs are directly linked to a specific arrangement and are recovered through that arrangement’s revenue.
When the development creates features with clear, identifiable applicability to future customers beyond the current one, classification as internally developed software may be more appropriate.
Getting the Amortization Period Right
Contract assets are amortized over the period during which the entity expects to transfer the related goods or services. For SaaS arrangements, this is typically the contract term, including expected renewal periods if renewals are reasonably certain.
The amortization period requires judgment. Consistent application across similar contracts is also generally required.
After the go-live date has gone live. Post-go-live operational costs, maintenance, bug fixes, minor enhancements, are expensed as incurred. Tracking and documenting this transition clearly is what gives finance teams confidence in the position.
Subcontractor Development Costs
Third-party development costs, payments to development partners for building platform features, follow the same framework. If the development partner is building features that meet the three capitalization criteria for contractual costs, those costs should be recorded on the balance sheet and amortized over the contract life.
Seeing It in Action
A software company contracts a third-party development partner for $110,000 to build features for its proprietary platform. The features are developed specifically for a SaaS contract with a five-year term.
Management evaluates whether the development creates capabilities applicable to future contracts. The features are specific enough that future applicability is not discernible at the time of development. Management classifies the costs as contract assets because they relate directly to the current contract and will be recovered through its revenue.
The $110,000 is deferred and amortized over the five-year contract term beginning at the go-live date. The income statement reflects approximately $22,000 per year rather than a single-period $110,000 charge.
At Lavoie CPA, we work with software and SaaS companies ready to make that story as accurate as it can be.