Middle Road Media: A Codification Research Case on the Accounting for Software Development Activities

ABSTRACT: The accounting for software development costs is a complex issue within the financial accounting curriculum. While intermediate-level texts address the relevant issues, this case provides a rich context for students to learn and apply knowledge of the topic while developing critical-thinking and professional research skills. The instructional case addresses a hypothetical scenario of a company's development of an internal-use software system that ultimately prompts the creation of a software product sold by the company to customers. Students are required to determine the appropriate recognition of the software development costs, as well as the presentation of those costs and proceeds from customers on the company's financial statements.

Keywords: FASB Codication; nancial reporting; software development.

THE CASE

M

iddle Road Media, Inc. (hereafter, MRM) produces a monthly political magazine, which it sells on a 12-month subscription basis. To meet the daily demands of political readers, MRM also produces a daily blog that includes contributions from many authors who provide commentary on current political issues. During the last quarter ofFY2017, company management solidified plans to expand its services to ''premium'' online contentadditional commentaries, interviews with key political figures, short documentaries, etc.which will provide an additional revenue stream. As part of this strategy, management decided it was necessary to revamp some of its key systems to provide the company with the appropriate information to enable it to deliver services in an optimal way.

To partially address this initiative, MRM management needed a new customer relationship management (CRM) database, as the company previously managed customer account information (other than billing information, which is included in the accounting system) through an archaic off-the-shelf database system. This database demanded extensive maintenance efforts on the part of MRM's customer service and billing staff to coordinate information between systems and update key customer information. For many years, it served the company's needs, but with the growth of the subscription base and competitive forces, a new system was warranted.

Development of the System

In a planning meeting, key employees from different company departments (hereafter, the team) determined that the new system must be integrated with the company's accounting system while maintaining its independent functionality. To reduce staff time spent updating customer information in the system, the team wanted to integrate the new software with the existing customer portal such that customers could update profile data, etc. Since this type of design would require a sophistication unique to MRM, the team decided it would be appropriate to build an in-house system. Given the limited information technology (IT) capabilities at the company, the team chose to retain the services of Dynamic Consulting, a firm specializing in the development of fully functional systems integration. Per the agreement, Dynamic firm professionals conducted the entire project without requiring any labor resources from MRM. However, the professionals instructed the company to purchase a new computer server specifically dedicated to the new system.

136

TABLE 1

Timeline of Events for CRM Development

February 22, 2018Dynamic begins designing the CRM application

May 9, 2018Dynamic completes the formal design process and begins SQL coding

July 23, 2018Dynamic finishes the substantial portion of coding and begins testing the application November 11, 2018Dynamic completes testing and installs application on the company's server November 25, 2018The company begins using the application

On February 22, 2018, Dynamic began creating the system, and the project was completed and placed into service on November 25 of the same year. The timeline of events is displayed in Table 1.

While Dynamic professionals completed the application on November 11, they spent the next two weeks, i.e., until November 25, training company employees on matters regarding the use of the system. Part of the training process involved educating the IT personnel of the company on maintenance issues. After November 25, Dynamic's involvement in the project was complete.

In determining the financial reporting of the new system, the company Controller, Sara Larson, produced conclusions for the 2018 costs, which are presented in Table 2.

Ms. Larson, through discussions with the Dynamic consultants and MRM IT personnel, also determined that the system would be useful for approximately five years. As such, the intangible asset was amortized on a straight-line basis for one month on the 2018 financial statements. The 2018 balance sheet contained the necessary line items, presented in Table 3, for the intangible assets section.

Subsequent Activity

After one month of use, the team, still intact from the beginning of the project, felt it necessary to perform an independent systems audit as part of the review procedures and ongoing significant maintenance for the new system. Because Dynamic was not independent with respect to the system, the team solicited the services of ZD Consulting to perform the engagement. The audit process commenced on January 27, 2019 and took two weeks to complete (one week after the 2018 financial statements were issued). While the audit did not turn up any significant issues, the ZD auditing team presented an interesting recommendation: MRM should sell the software to companies with similar needs in non-competing industries.

The ZD auditors discussed with MRM management the problems faced by clients in other industries with respect to their CRM systems. The auditors were confident that MRM's system offered a workable solution for some of these clients. The auditors believed that three to five clients would be interested in the software application, but some changes would be required to render the software user-friendly and in saleable condition. Besides performing systems audits, ZD also specialized in assisting companies in developing software applications to be sold, as well as providing software support. As such, ZD offered to prepare a proposal for the company, at no charge, detailing how the process would work.

ZD was very interested in this project because it offered great fee potential for the firm. First, this situation provided ZD the opportunity to generate significant fees in transforming the company's CRM system into a marketable product. Second, since MRM lacked the foundation for offering customer support for the marketed product, ZD could also earn business from MRM's potential software customers, who would likely demand support services. MRM management was also interested in how the sale of the software could introduce another primary revenue stream to its income statement. As such, the company agreed to listen to ZD's proposal.

Cost Activity

TABLE 2

Financial Reporting Actions for CRM System Development

Financial Reporting Decision

Associated Cost

Costs incurred prior to February 22, 2018 for system planning

Included in Operating Expenses

$110,000

Dynamic fees for activities from February 22, 2018-November 11, 2018

Capitalized as an intangible asset

$6,390,000

Costs incurred from November 11, 2018-November 25, 2018 for training

Included in Operating Expenses

$185,000

Costs incurred after November 25, 2018 for maintenance

Included in Operating Expenses

$329,000

Middle Road Media: A Codification Research Case on the Accounting for Software Development Activities137

TABLE 3

2018 Balance Sheet Line Items for CRM System

Account NameAmount

CRM System$6,390,000

Accumulated Amortization: CRM System(106,500)

The proposal was comprehensive, and included a detailed market analysis for similar products and the steps required to prepare the product for the market. Per the proposal, ZD lined up three commitments (along with non-disclosure agreements) from its clients that were interested in purchasing a version of MRM's software. Additionally, two other clients expressed interest, but needed more time to determine whether the software was suitable for their needs. Overall, the analysis indicated a high demand for such a product in a few key industries. For the software to be marketed, ZD suggested that the current CRM application would require a re-designed graphical user interface, significant new coding (approximately 50 percent of the coding in MRM's in-house system would need to be replaced) in an updated programming language, and intensive beta testing. After agreeing to ZD's proposal, the creation of the software product was initiated on March 1. While ZD professionals were responsible for building the software product, the contract clearly stipulated that MRM controlled the development of the product, thereby assuming all risks during and after the development process. Additionally, MRM was to control the software after completion of the project and was responsible for fulfilling the contracts with all customers (including the three commitments from ZD clients). Table 4 provides a timeline of the development process and the cumulative cost incurred in

2019 for the project.

While the finished product contained features and functionality not present on the CRM system developed in 2018 and used by MRM, the work performed by ZD did allow MRM to improve the functionality of its in-house system. The contract between MRM and the three customers stipulated that the software version completed on August 31 would be installed on the customers' servers by MRM employees on September 15. The agreed-upon price was $500,000 per customer, payable in two installments ($250,000 on September 15 and $250,000 on December 19). Because this was the first product offered by the company, the sales price did not include any software upgrades or customer support. However, ZD offered each customer a separate customer support contract with no involvement by MRM. By the end of 2019, MRM had focused significant resources on marketing the product to potential customers.

Main Case Requirements

While Ms. Larson is confident with regard to the U.S. GAAP reporting of the CRM system developed in 2018 and used by MRM, she is less certain as to the accounting for the software product developed for customers in 2019 due to the unique nature of the transaction as it relates to the company's business. You have been asked to research the relevant guidance to determine the proper course of action for the 2019 financial statements. Specifically, Ms. Larson is interested in how the fees paid to ZD for the activities from March 1-August 31 should be accounted for and how these costs, along with the fees generated from the three customers, should be presented on the 2019 financial statements. As part of this task, you should perform the following activities:

(1)Consult the Financial Accounting Standards Board Accounting Standards Codification to find appropriate guidance on the issues presented in the case.

TABLE 4

Timeline for Development of 2019 Software

DateMilestone

Cumulative 2019 Cost

March 1, 2019ZD initiates design of new graphical user interface$0 May 13, 2019ZD completes graphical user interface design and commences additional coding$1,135,000

July 23, 2019ZD completes working model for the software that is ready for beta testing with

three confirmed customers

$3,083,000

August 31, 2019

Beta testing is completed by ZD

$3,758,000

September 15, 2019

Three customers purchase software

$3,758,000

138

(2)Prepare a detailed, 1.5-2-page memo to Ms. Larson that includes the relevant issues for this situation, the appropriate financial reporting guidance, and your conclusion regarding the treatment of the fees generated and costs incurred for the software sold in 2019.

Optional Requirements

Optional Requirement 1

Analyze Ms. Larson's accounting for the CRM System in 2018. Specifically, determine whether her decisions regarding the (1) capitalization versus expensing of costs and (2) amortization of the CRM system are supported by U.S. GAAP. In a written response, please address the specific evidence from the case, relevant guidance from the Financial Accounting Standards Board Accounting Standards Codification, and adjustments, if any, that should be made to the 2018 financial statements.

Optional Requirement 2

In addition to the text from the case, consider the following additional details:

MRM management felt that its first three software clients could play a crucial role in MRM's future strategy to create market awareness for its software product. Through discussions with the three companies, MRM management learned that each company was scheduled to participate in industry conventions in the first quarter of 2020. According to the clients, these conferences typically provide companies and their employees the opportunity to interact with industry association members and competitors and discuss industry-specific developments. Companies normally receive booth space in the main convention area, and some of the industry participants give presentations in adjacent conference rooms on topics of interest. MRM management believed that these conferences would be a strategic venue to market their software products. However, admission to the conferences was exclusive to industry participants who paid significant association dues, and thus MRM had no way of attending the conferences independently, nor did they have established business connections with other companies within these industries. Because of the significant opportunity, though, MRM management asked the three initial clients if they would promote the product at their respective conventions. Specifically, MRM wanted the companies to offer a demonstration of the software to other conference attendees and devote booth space to marketing pamphlets for the software. Each company agreed to MRM's request, but demanded a substantial fee given the significance of the promotional efforts and the uniqueness of such activity at the conferences. As such, MRM's sales contracts for each of the three customers included an agreement for the customers to provide the software demonstrations and display pamphlets in exchange for a fee of $15,000 (for a total of

$45,000), payable on December 19, 2019.

Optional requirement. Considering the evidence from the case, including the additional information provided, identify the revenue recognition issues that potentially impact the accounting for the sales contracts in 2019. In the process, research the appropriate guidance from the Financial Accounting Standards Board Accounting Standards Codification to determine how these issues should be addressed. In a written response, provide a summary of the issues identified, the relevant guidance, and a conclusion as to the appropriate treatment of each issue.

Middle Road Media: A Codification Research Case on the Accounting for Software Development Activities

ABSTRACT: The accounting for software development costs is a complex issue within the financial accounting curriculum. While intermediate-level texts address the relevant issues, this case provides a rich context for students to learn and apply knowledge of the topic while developing critical-thinking and professional research skills. The instructional case addresses a hypothetical scenario of a company's development of an internal-use software system that ultimately prompts the creation of a software product sold by the company to customers. Students are required to determine the appropriate recognition of the software development costs, as well as the presentation of those costs and proceeds from customers on the company's financial statements.

Keywords: FASB Codication; nancial reporting; software development.

THE CASE

M

iddle Road Media, Inc. (hereafter, MRM) produces a monthly political magazine, which it sells on a 12-month subscription basis. To meet the daily demands of political readers, MRM also produces a daily blog that includes contributions from many authors who provide commentary on current political issues. During the last quarter ofFY2017, company management solidified plans to expand its services to ''premium'' online contentadditional commentaries, interviews with key political figures, short documentaries, etc.which will provide an additional revenue stream. As part of this strategy, management decided it was necessary to revamp some of its key systems to provide the company with the appropriate information to enable it to deliver services in an optimal way.

To partially address this initiative, MRM management needed a new customer relationship management (CRM) database, as the company previously managed customer account information (other than billing information, which is included in the accounting system) through an archaic off-the-shelf database system. This database demanded extensive maintenance efforts on the part of MRM's customer service and billing staff to coordinate information between systems and update key customer information. For many years, it served the company's needs, but with the growth of the subscription base and competitive forces, a new system was warranted.

Development of the System

In a planning meeting, key employees from different company departments (hereafter, the team) determined that the new system must be integrated with the company's accounting system while maintaining its independent functionality. To reduce staff time spent updating customer information in the system, the team wanted to integrate the new software with the existing customer portal such that customers could update profile data, etc. Since this type of design would require a sophistication unique to MRM, the team decided it would be appropriate to build an in-house system. Given the limited information technology (IT) capabilities at the company, the team chose to retain the services of Dynamic Consulting, a firm specializing in the development of fully functional systems integration. Per the agreement, Dynamic firm professionals conducted the entire project without requiring any labor resources from MRM. However, the professionals instructed the company to purchase a new computer server specifically dedicated to the new system.

136

TABLE 1

Timeline of Events for CRM Development

February 22, 2018Dynamic begins designing the CRM application

May 9, 2018Dynamic completes the formal design process and begins SQL coding

July 23, 2018Dynamic finishes the substantial portion of coding and begins testing the application November 11, 2018Dynamic completes testing and installs application on the company's server November 25, 2018The company begins using the application

On February 22, 2018, Dynamic began creating the system, and the project was completed and placed into service on November 25 of the same year. The timeline of events is displayed in Table 1.

While Dynamic professionals completed the application on November 11, they spent the next two weeks, i.e., until November 25, training company employees on matters regarding the use of the system. Part of the training process involved educating the IT personnel of the company on maintenance issues. After November 25, Dynamic's involvement in the project was complete.

In determining the financial reporting of the new system, the company Controller, Sara Larson, produced conclusions for the 2018 costs, which are presented in Table 2.

Ms. Larson, through discussions with the Dynamic consultants and MRM IT personnel, also determined that the system would be useful for approximately five years. As such, the intangible asset was amortized on a straight-line basis for one month on the 2018 financial statements. The 2018 balance sheet contained the necessary line items, presented in Table 3, for the intangible assets section.

Subsequent Activity

After one month of use, the team, still intact from the beginning of the project, felt it necessary to perform an independent systems audit as part of the review procedures and ongoing significant maintenance for the new system. Because Dynamic was not independent with respect to the system, the team solicited the services of ZD Consulting to perform the engagement. The audit process commenced on January 27, 2019 and took two weeks to complete (one week after the 2018 financial statements were issued). While the audit did not turn up any significant issues, the ZD auditing team presented an interesting recommendation: MRM should sell the software to companies with similar needs in non-competing industries.

The ZD auditors discussed with MRM management the problems faced by clients in other industries with respect to their CRM systems. The auditors were confident that MRM's system offered a workable solution for some of these clients. The auditors believed that three to five clients would be interested in the software application, but some changes would be required to render the software user-friendly and in saleable condition. Besides performing systems audits, ZD also specialized in assisting companies in developing software applications to be sold, as well as providing software support. As such, ZD offered to prepare a proposal for the company, at no charge, detailing how the process would work.

ZD was very interested in this project because it offered great fee potential for the firm. First, this situation provided ZD the opportunity to generate significant fees in transforming the company's CRM system into a marketable product. Second, since MRM lacked the foundation for offering customer support for the marketed product, ZD could also earn business from MRM's potential software customers, who would likely demand support services. MRM management was also interested in how the sale of the software could introduce another primary revenue stream to its income statement. As such, the company agreed to listen to ZD's proposal.

Cost Activity

TABLE 2

Financial Reporting Actions for CRM System Development

Financial Reporting Decision

Associated Cost

Costs incurred prior to February 22, 2018 for system planning

Included in Operating Expenses

$110,000

Dynamic fees for activities from February 22, 2018-November 11, 2018

Capitalized as an intangible asset

$6,390,000

Costs incurred from November 11, 2018-November 25, 2018 for training

Included in Operating Expenses

$185,000

Costs incurred after November 25, 2018 for maintenance

Included in Operating Expenses

$329,000

Middle Road Media: A Codification Research Case on the Accounting for Software Development Activities137

TABLE 3

2018 Balance Sheet Line Items for CRM System

Account NameAmount

CRM System$6,390,000

Accumulated Amortization: CRM System(106,500)

The proposal was comprehensive, and included a detailed market analysis for similar products and the steps required to prepare the product for the market. Per the proposal, ZD lined up three commitments (along with non-disclosure agreements) from its clients that were interested in purchasing a version of MRM's software. Additionally, two other clients expressed interest, but needed more time to determine whether the software was suitable for their needs. Overall, the analysis indicated a high demand for such a product in a few key industries. For the software to be marketed, ZD suggested that the current CRM application would require a re-designed graphical user interface, significant new coding (approximately 50 percent of the coding in MRM's in-house system would need to be replaced) in an updated programming language, and intensive beta testing. After agreeing to ZD's proposal, the creation of the software product was initiated on March 1. While ZD professionals were responsible for building the software product, the contract clearly stipulated that MRM controlled the development of the product, thereby assuming all risks during and after the development process. Additionally, MRM was to control the software after completion of the project and was responsible for fulfilling the contracts with all customers (including the three commitments from ZD clients). Table 4 provides a timeline of the development process and the cumulative cost incurred in

2019 for the project.

While the finished product contained features and functionality not present on the CRM system developed in 2018 and used by MRM, the work performed by ZD did allow MRM to improve the functionality of its in-house system. The contract between MRM and the three customers stipulated that the software version completed on August 31 would be installed on the customers' servers by MRM employees on September 15. The agreed-upon price was $500,000 per customer, payable in two installments ($250,000 on September 15 and $250,000 on December 19). Because this was the first product offered by the company, the sales price did not include any software upgrades or customer support. However, ZD offered each customer a separate customer support contract with no involvement by MRM. By the end of 2019, MRM had focused significant resources on marketing the product to potential customers.

Main Case Requirements

While Ms. Larson is confident with regard to the U.S. GAAP reporting of the CRM system developed in 2018 and used by MRM, she is less certain as to the accounting for the software product developed for customers in 2019 due to the unique nature of the transaction as it relates to the company's business. You have been asked to research the relevant guidance to determine the proper course of action for the 2019 financial statements. Specifically, Ms. Larson is interested in how the fees paid to ZD for the activities from March 1-August 31 should be accounted for and how these costs, along with the fees generated from the three customers, should be presented on the 2019 financial statements. As part of this task, you should perform the following activities:

(1)Consult the Financial Accounting Standards Board Accounting Standards Codification to find appropriate guidance on the issues presented in the case.

TABLE 4

Timeline for Development of 2019 Software

DateMilestone

Cumulative 2019 Cost

March 1, 2019ZD initiates design of new graphical user interface$0 May 13, 2019ZD completes graphical user interface design and commences additional coding$1,135,000

July 23, 2019ZD completes working model for the software that is ready for beta testing with

three confirmed customers

$3,083,000

August 31, 2019

Beta testing is completed by ZD

$3,758,000

September 15, 2019

Three customers purchase software

$3,758,000

138

(2)Prepare a detailed, 1.5-2-page memo to Ms. Larson that includes the relevant issues for this situation, the appropriate financial reporting guidance, and your conclusion regarding the treatment of the fees generated and costs incurred for the software sold in 2019.

Optional Requirements

Optional Requirement 1

Analyze Ms. Larson's accounting for the CRM System in 2018. Specifically, determine whether her decisions regarding the (1) capitalization versus expensing of costs and (2) amortization of the CRM system are supported by U.S. GAAP. In a written response, please address the specific evidence from the case, relevant guidance from the Financial Accounting Standards Board Accounting Standards Codification, and adjustments, if any, that should be made to the 2018 financial statements.

Optional Requirement 2

In addition to the text from the case, consider the following additional details:

MRM management felt that its first three software clients could play a crucial role in MRM's future strategy to create market awareness for its software product. Through discussions with the three companies, MRM management learned that each company was scheduled to participate in industry conventions in the first quarter of 2020. According to the clients, these conferences typically provide companies and their employees the opportunity to interact with industry association members and competitors and discuss industry-specific developments. Companies normally receive booth space in the main convention area, and some of the industry participants give presentations in adjacent conference rooms on topics of interest. MRM management believed that these conferences would be a strategic venue to market their software products. However, admission to the conferences was exclusive to industry participants who paid significant association dues, and thus MRM had no way of attending the conferences independently, nor did they have established business connections with other companies within these industries. Because of the significant opportunity, though, MRM management asked the three initial clients if they would promote the product at their respective conventions. Specifically, MRM wanted the companies to offer a demonstration of the software to other conference attendees and devote booth space to marketing pamphlets for the software. Each company agreed to MRM's request, but demanded a substantial fee given the significance of the promotional efforts and the uniqueness of such activity at the conferences. As such, MRM's sales contracts for each of the three customers included an agreement for the customers to provide the software demonstrations and display pamphlets in exchange for a fee of $15,000 (for a total of

$45,000), payable on December 19, 2019.

Optional requirement. Considering the evidence from the case, including the additional information provided, identify the revenue recognition issues that potentially impact the accounting for the sales contracts in 2019. In the process, research the appropriate guidance from the Financial Accounting Standards Board Accounting Standards Codification to determine how these issues should be addressed. In a written response, provide a summary of the issues identified, the relevant guidance, and a conclusion as to the appropriate treatment of each issue.