Challenges of Accounting in IT and Software Industry

Gireesh Kumar, Partner Audit and Assurance

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    IT and Software sector is one of the complex industries in terms of accounting and reporting of financial statements. There is high global increase in the spend on IT system and Services, especially in post-COVID period. When comparing to earlier IT Industry, the sector has grown vastly to cloud computing, quantum computing, artificial intelligence and cyber security. It is very critical for the accountants and auditors to understand the products and services, technical terms, accounting terms, organizational structure and revenue recognition policies as per IFRS 15.

    Industry-Specific Expenditures

    1. Software research cost

      The cost during research phase generally includes manpower cost, both employee & freelancer, fees for certain license etc. All the cost in the research phase must be expensed off since in this phase the company will be researching the unknown. At this stage no economic benefit can be expected.

    2. Software development cost

      The nature of the cost incurred during development phase is mostly similar to that in research phase. However, the development cost can be capitalized from the point in time in which technological feasibility is established up until the point the product is ready for general release.The capitalized costs can subsequently be amortized over the life of the product.

    3. Cost to obtain contracts

      These may take form of any sales commission, modification in the product for obtaining a contract.  Any incremental costs of obtaining a contract must be capitalized and amortized on a straight-line basis over the expected customer relationship period if the company expects to recover those costs.

    4. Startup cost

      The startup cost for an IT company generally are cost for setting up the Infrastructure and technology requirements like equipment, data storage and includes domain cost, web design, advertisement, marketing and surveys. These cost has to be expensed of as and when incurred

    5. Cost of IP rights

      The company licenses and sells rights to certain of its intellectual property (IP) like internally developed patents, trade secrets and technological know-how. Some of the IP transactions are licensing/royalty-based while some are transaction-based sales/other transfers. Licensing arrangements include IP partnerships whereby a business partner licenses source code and becomes responsible for developing, maintaining and enhancing the product.The accounting treatment requires assessment of the pattern of economic benefits flowing to the company

    6. Product warranty cost

      Providing warranties are most common part of IT sales and services. Any cost of standard warranties should be accrued when the corresponding revenue is recognized

    Industry-Specific Revenues

    1. Sale of licenses

      Companies that are selling IP licenses are commonly known as SaaS providers. They are mostly providing licenses on a subscription model which are centrally hosted. Revenue of license providers can be categorized as follows:

      1. When licensing of intellectual property is a distinct good or service or where sale of license is a predominant component in a performance obligation. Then,
        • Revenue from right to access the license is recognized over a period of time.
        • Revenue from right to use the license is recognized at the point in time at which the license is granted.
      2. When the license of IP is a non-distinct component of a performance obligation or a non-dominant component of a performance obligation, the general criteria for revenue recognition has to be followed
    2. Training services and custom development services

      Determining the pattern of revenue recognition needs an evaluation of the transfer of control, benefits of the service and right of payment.
      The revenues are recognized over the point of time if;

      • They sell these services on a stand-alone basis or
      • The customer can hire a third party to perform these services

      The revenue is recognized over time if;

      • Services may be delivered over a period or
      • Services are based on meeting certain milestones or achieving other metrics which requires the customer acceptance on the progress of the service.
    3. Sale of third-party hardware and software

      An assessment to be done to confirm if the company is acting as an agent or principal. The “control of the products or services” needs to be considered before they are transferred to the customer. The revenue from sales of third-party vendor products or services is recorded net of costs when the company is acting as an agent. When the company is the principal for the transaction then revenue is recognized on gross basis.

    4. Implementation/installation/integration service revenue

      Over time revenue recognition is normally followed for these services but a full understanding of the situation is required. The factor to consider here is to determine if clients have purchased these services to get desired features and function or whether customer is simply outsourcing for convenience.If the customer can implement the software but has outsourced, then the services are termed as “Distinct” and then revenue should be recognized as “at the point of time”

    5. Revenue from extended warranty

      These revenue from such contracts are initially recorded as deferred income and subsequently recognized on a straight-line basis over the delivery period.

    6. Revenue in case of termination right clauses

      Termination clauses are often a part of software sales contracts. If a customer can terminate a contract without substantive cost or penalty, only the noncancelable portion of the contract is accounted for revenue. The undelivered performance obligations associated with such arrangements must be excluded from deferred revenue.

    7. Upfront fees

      IT companies receives payment for part or all of a service before completing the service. This requires companies to consider whether the fee is associated with the transfer of promised goods or services or an advance payment for future goods or services

    Basics of Revenue Recognition

    Conclusion
    To overcome the accounting challenges in IT and software industry and for a better presentation of financial statements, following are very important factors:

    • Understanding the business
    • Understanding the contract with customers
    • Understanding the cost elements

     

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