Plugs in a row: coordination between accounting, IT key to planning, recording projects.

For years, accounting and information technology have operated in two different worlds. Chief information officers generally have left the accounting issues to accountants, while accountants have left IT managers to attend to their managerial tasks.

But that's no longer the case.

Accounting rules are just beginning to catch up to the explosive growth of technology and to guidelines for recognizing IT costs.

Accounting rules released by FASB and the AICPA since 1998 indicate that technology costs need to be categorized and better defined.

An annual survey by Computer Economics Inc. shows that the median spending on IT is about 1.8 percent of revenue (www.computereconomics.com). Decisions made by IT managers may have implications on the way these costs should be accounted for under GAAP. So it's imperative that accountants and IT managers communicate and are aware of the implications and effects of each other's decisions regarding how software costs should be accounted for.

ACCOUNTING FOR IT COSTS SINCE 1998

Lack of standard accounting methodology during a period in which companies increased capacity to staff large IT departments and embarked on internal development resulted in the issuance of Statement of Opinion 98-1: Accounting for the Costs of Computer Software Developed or Obtained for Internal Use.

SOP 98-1 divides software projects into three stages, each with different accounting treatment:

Preliminary Project Stage: Conceptual formulation and evaluation of software alternatives; determination of existence of needed technology; and final selection of alternatives.

Application Development Stage: Design of chosen path, including software configuration and software interfaces; coding; installation to hardware; and testing, including parallel processing phase.

Post-Implementation/Operation Stage: Training and application maintenance.

Before accounting for the costs, an organization must consider the definition of internal use. Should a software package be intended for the external market, a company needs to apply Statement No. 86.

The preliminary project stage resembles R&D development in that the exploratory phase of software development may not yield a concrete product. Projects in this phase follow Statement of Financial Accounting Standards No. 2, which require costs to be expensed in the period incurred.

User training or code maintenance costs fall under the post-implementation stage and are deemed part of normal operational costs and thus are expensed.

The application development stage is the only one where costs can be capitalized. Since resources are involved in creating an asset that will provide a benefit to the company for several years, it is logical that such costs be capitalized.

Costs may include salaries for employees who are directly involved in developing the software and fees for consultant services. These costs are amortized over the expected period of benefit, taking into consideration the pace of technological obsolescence.

ACCOUNTING FOR WEBSITE DEVELOPMENT COSTS

When the internet was in its nascent stages, corporate websites functioned as marketing brochures. As marketing material, accounting rules dictate that costs are expensed in the period incurred.

But between 1997 and 1999, there was an explosive growth in the number and complexity of corporate websites. No longer just brochures for displaying wares, websites became e-commerce channels.

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Companies also took advantage of the network infrastructure to allow preferred suppliers access to internal data, termed an extranet.

Website development costs ballooned to include development of software to run the website, production of content and purchase of computer hardware. Companies embarked on projects to integrate "front-end" customer transactions, such as sales and payment, to "back-end" systems of inventory and finance.

In March 2000, FASB's Emerging Issues Task Force reached a consensus on Issue 00-2, Accounting for Web Site Development Costs, and whether website-related costs should be capitalized.

EITF 00-2 treats websites as internally developed software and divides the initial development into five stages: planning; application and infrastructure development (including hardware, web hosting, domain name registration); graphics development; content development; and operating.

Application and infrastructure development, and graphics and content development roughly correlate to applications development as defined under SOP 98-1. Planning and operating stage costs should be expensed as incurred.

Software development and graphic design tied to website production can be capitalized as covered by SOP 98-1.

Additionally, websites that function mostly as advertising are deemed to be advertising costs and are covered by SOP 93-7: Reporting on Advertising Costs. Data-driven sites that allow customers to control their transactions would be considered an operational cost.

CHALLENGES AND IMPLICATIONS

These accounting rules introduce a set of challenges for IT management. Namely, managers need to estimate and allocate labor costs to IT projects and to the specific phases within them, which are often intertwined.

Applications development follows an iterative model, in which a circular path--planning, design, coding and testing--is repeated. Developers participating in the lifecycle would be required to identify time spent in each phase.

Business users who participate in software testing also may need to identify time spent in development. Combination projects in which the addition of functionality, systems modifications or upgrades are executed together also would require tracking.

Suppose a system functions as intended, but users request a set of modifications to improve usability. The effort may be considered an upgrade.

However, suppose those same functions were identified as running on less than optimal code leading to long processing time. Then efforts to revise the design would be considered maintenance.

User requests are the common drivers of redesign initiatives and in a majority of cases, maintenance and upgrades are intertwined. Such detailed classification of intent and task time may be easier for companies with strong project management practices, but even they find such detailed time allocation a daunting task.

Internal-use software that requires large expenditures and relies on developer expertise often relates to enterprise systems, which is seen as a tool to automate manual processes. Businesses recognize that these tools could help them correct inefficient business processes and gain strategic advantages.

Products by SAP, Siebel and Oracle, for example, all tout highly customizable modules that can be configured to the specifications of distinct industries. Investing in expensive software only to model the application after inefficient or outdated processes would be illogical and thus companies that purchase these systems often use the opportunity to conduct business re-engineering projects.

If a company carries forward business re-engineering projects, it must carefully consider how accounting views these costs.

FASB EITF Issue No. 97-13 in 1997, Accounting for Costs Incurred in Connection with a Consulting Contract or an Internal Project That Combines Business Process Reengineering and Information Technology Transformation, requires that re-engineering activity costs should be expensed, rather than capitalized. Since business processes may need to be adjusted to reflect changing conditions in the normal course of business, it is considered an operational cost.

Meanwhile, software development costs that complement re-engineering activities should be capitalized per SOP 98-1.

Yet again, IT management is tasked to properly define the amount of time and cost of technology projects that involve process re-engineering.

To make things more complex, IT staff often performs cross-functional activities at various stages of the project, including business process re-engineering and systems design.

And as many companies can attest, grand IT projects do not always translate into process efficiencies or additional profits. Instead, projects are stalled due to lack of budgeting, unexpected implementation problems or are faced with outright nonfunctional systems. In this case, accounting standards require all costs be expensed.

ACCOUNTING AND IT MUST COMMUNICATE

Communication between accounting and IT professionals is vital as IT managers may alter their decisions based on the effect of those decisions upon accounting, and accounting should be aware of the choices and constraints IT managers face.

One may think these accounting rules would help to standardize financial reporting of IT expenses. However, industry analysts are quickly finding that a potential to abuse these accounting rules exists.

Some companies may disclose the costs of failed IT projects in the annual reports as part of infrastructure costs or just refer to those costs as an R&D project. On another front, executives who are facing failed projects have no incentive for owning up to project failure. Or, to get creative, a just-barely-functional system may be rolled out and a new project may be billed as the next-generation application.

As corporate IT expenditures grow, IT management should be made aware of the implications of any accounting changes that could be expected in coming years. As cost centers, IT managers are increasingly under pressure to deliver more functionality at a lower cost.

Executives are busy developing return on investment numbers and pitching strategies that cater to the customer and result in corporate profits.

The ability to determine whether costs are expensed or capitalized should be considered.

Although accounting is not a driver of technology projects, understanding and applying accounting considerations may help to justify some projects and scrap others, aiding IT in aligning projects to business goals.

Monique C. Chang is an MBA candidate at Baruch College, CUNY and can be reached at [e-mail].

Ariel Markelevich, Ph.D., CMA is an assistant professor at the C.W. Post School of Professional Accountancy at Long Island University and can be reached at [e-mail].