Capitalizing cost software development

[mark888]

xxx

[kamranACA]

Dears,

Can any body explain what this good fellow has asked?

Regards,

Kamran

[kamranACA]

Dear,

I have understood your question. I assume that the softwares have to be sold to customers. I was just signing off and and at the moment cannot write a detailed reply. I will tell you what is happening in WAPDA distribution companies and KESC where customers are charged more than the cost of labour and overheads actually incurred on installation of a electricity meter or transformer or whatever. I will give you examples, and will elaborate the treatement and logic for such treatment. It has to take some time which i am falling short of at the moment.

Hope to reply u soon.

Regards,

Kamran.

[kamranACA]

Dear,

I dont know why your query has been eliminated from the forum.

From your question, I assume that your organization deals in developing and selling the softwares. As per IAS-2 the softwares you develope become a part of your inventory unless these have been sold and meet the criteria of revenue recognition under IAS 18.

IAS 2 requires to state the inventories at cost or net realizable value (NRV) whichever is lower. The cost means the actual cost incurred in acquiring or producing the inventories. NRV means the estimated selling prices less costs incidental to such sales.

In my view, the softwares that are in the process of development and the softwares that have been developed but not delivered at the balance sheet date should be states at cost, unless the NRV is estimated to be lesser than the cost.

Accordingly, you cannot over-abosrb the labour or overheads in the cost thereof. The labour will be absorbed on actual spent basis instead of on applied basis at a specific rate.

Absorption of overheads has been discussed in paragraph 12 and 13 of IAS-2. Variable overheads have to be fully absorbed in the production using the actual output level as a basis for such absorption. Whereas, the fixed overheads cannot be fully absorbed unless the production achieved is substantially the normal capacity level / normal producing ability. This means that if the normal capacity of production is not met, even then the fixed overheads have to be absorbed using the normal capacity level as a basis for absorption so that the inventories may not be over-costed.

Your softwares will absorb

- labour on actual basis
- variable overheads on actual production level/basis
- fixed overheads on normal capacity level.

However, you can charge your customers over and above than what has been absorbed. I understand that charging to customers is normally not based upon man hours and is basically an agreed lumpsum amount. Still, if it has to be based upon some man hours, you can charge the customers for more man hours and evn for more rate per man hour.

WAPDA distribution companies while installing meters or transformers, charge to the customers 10 percent of material cost as labour charges and 16 percent of material cost as overhead charges based upon some rough estimations made by their finance department. Here, one point of difference lie. The softwares after the sale will most probably not constitute as part of your own assets. Rather, these would expectedly be the assets of the customers. But in WAPDA case all such meters and transformers remain the asset of the WAPDA companies irrespective that the material cost plus labour and over heads(on estimated basis) have been recovered.

For recognising this transaction, they use the principles of IAS 20 although it does not apply to this case. They pass the following entry

Fixed Assets (DEBIT) Rupees 100

Bank account (DEBIT) Rupees 126

Material issued from stores (CREDIT) Rupees 100

Deferred Credit account (CREDIT) Rupees 100

Labour and over head recovery accounts (Other Income)Rupees 26


Since there is no direct linkage of labour and overheads with the amount recovered and expenses cannot be credited, therefore, other income is credited in respect of roughly recovered labour and overheads. They, dont capitalize it for two reasons, firstly, the labour to be capitalized is extremely negligble and cannot be prorated on all the services being provided by the same employees and normally no overheads are actually incurred on such works by WAPDA companies. This remains only a matter of charging the customers more than what has costed to the company. Therefore, 26 percent amount is immediately recognized as income.

Rest of 100 percent amount pertains to the material cost that is identifiable. Since asset under the agreement remains in the ownership of WAPDA company despite of recovery of its cost, it has to be recognised as a fixed asset. Further, as the company has incurred no cost in respect of such equipment, a deferred credit is recognised to give effect to the amount recovered against asset capitlaized.

After recognising the asset and deferred credit both are depreciated with the same depreciation/amortization rate. Due to this, there remains no impact on profit and loss account as the amount of depreciation of fixed assets (expense) is equal to the amount of amortization of deferred credit (income).

Therefore, if the softwares have to be sold outrightly, there will arise no problem. You carry your inventory at cost or NRV whichever is less and when such inventory is sold, charge the customer with whatever amount calculated on whatever basis and state this selling prioce as your sales. Against this sales you will recognise the cost/NRV of the sold inventories as expense during any specific period.

However, if softwares have to continue as your assets even after sale/charging to customer under any specific agreement. You can follow the procedure being followed by the WAPDA companies and can charge them on whatever basis and whatever rate you may agree with customers under that agreement.

Hope you would find this post beneficial.

Best regards,

Kamran.