Accounting for core system conversions
Your financial institution may choose to change its core accounting system for a variety of reasons. In those instances, management will put a lot of time, effort and resources into that decision. These changes may be exciting because of the opportunities they can create, but they often come with particular accounting issues that management needs to address as part of the change.
Here are some common issues your financial institution may face when accounting for conversion costs:
Capitalization vs. expense
Accounting rules for internal use software are found in ASC 350-40. These standards provide guidelines for when internal and external costs incurred to develop or acquire internal-use software should be capitalized or expensed.
Examples of costs that should be capitalized include:
- Acquiring software
- Designing the chosen path, including software configuration
- Coding
- Installing hardware
- Testing, including parallel processing
These costs include external direct costs of materials and services, such as fees paid to third parties for developing the software or the software itself and internal costs directly related to developing software, such as payroll and payroll-related costs for employees who devote time to the internal-use computer software project.
Examples of costs that shouldn’t be capitalized include:
- Costs incurred during the preliminary project stage, including strategic decision-making, determining performance requirements, evaluating alternatives and selecting a vendor and/or consultant.
- Training.
- Data conversion costs, including time spent physically converting data, purging or cleansing existing data, reconciling data in the old and new systems and creating new or additional data.
- General administrative costs and overhead.
- Costs incurred after the software is ready for its intended use, such as routine maintenance.
Capitalized software should be amortized over the estimated useful life of the software, generally on a straight-line basis. Amortization should begin when the software is ready for its intended use, regardless of whether it has been placed in service.
Software is also subject to impairment when a triggering event occurs or development is no longer probable of completion.
Contract incentives and termination of existing contracts
Vendors may provide a financial institution with incentives to entice it to enter the contract. These contract incentives may include an upfront payment to the institution, reduced or no payments for a certain period of time or credits to be used for certain future purchases or payments.
ASC 705-20-25 discusses the accounting for consideration from a vendor. Consideration may consist of cash amounts received or to be received, credit or other items the institution can apply against the amounts owed to the vendor. Paragraph 25-1 says any consideration from a vendor is accounted for as a reduction of the purchase price of the goods or services acquired from the vendor (except when the consideration is tied directly to other transactions as outlined in the paragraph).
In certain instances, the vendors provide these incentive payments to offset costs the institution may have to terminate an existing contract. Since these are two separate contracts (the existing contract with the old vendor and the new contract with the new vendor), each contract should be accounted for individually. ASC 420-10-25-12 states that “a liability for costs to terminate a contract before the end of its term shall be recognized when the institution terminates the contract in accordance with the contract terms.”
The termination fee for the existing contract is properly recognized in the period the contract is terminated. This does not affect the expense recognition principles for the new contract.
Consulting fees paid to negotiate a contract
Institutions may hire a consultant to negotiate the fee for a new core accounting software contract. These consultants often look for ways to save money on those contracts by eliminating unnecessary products or services or reducing the overall fee. In these instances, the consultant’s fee is often a percentage of the total cost savings realized over the contract term and is paid in one lump sum when the contract is signed.
As discussed previously, only internal and external costs incurred to develop or obtain internal use software shall be capitalized. These costs include fees paid to third parties for services provided to develop the software and costs incurred to obtain computer software from third parties.
However, costs to negotiate the contract price are not necessary to develop or obtain the software. Therefore, fees paid to such a consultant should not be capitalized as part of internal-use software.
Some have argued that such consulting fees should be capitalized as a prepaid asset and recognized over the term of the contract. Although there isn’t any specific guidance in FASB’s codification regarding the treatment of consulting fees as a prepaid asset, prepaid assets are generally recognized when the institution has received goods that will be utilized in future periods (e.g., prepaid supplies) or when the third party promises to perform services over a future period (e.g., prepaid maintenance).
In this scenario, the institution has not received any goods and the consultant has already performed its services — that is, negotiating the price of the contract. Even though the institution will see lower future contractual payments, the institution has already received the benefit of the consultant’s services. Consequently, there is no justification for recognizing the consultant’s fees as a prepaid asset.
Many consultants will agree to provide services in subsequent years in addition to the initial service of negotiating the contract price. In these cases, the institution should determine the fair value of the initial services (e.g., negotiating the contract price) and the subsequent services and allocate the consulting fee based on the relative fair value of the services being performed.
In many of these consulting arrangements, the ongoing services to be performed by the consultant are trivial compared to the contract negotiation service, and it is likely a minimal amount would be allocated to those ongoing services.
Hosting arrangements
New core accounting system contracts may include hosting arrangements, or cloud computing arrangements (CCAs), such as software-as-a-service arrangements, where the financial institution does not take possession of the software. Instead, the software resides on the vendor’s or a third-party’s hardware, and the institution accesses the software remotely.
CCAs may include a traditional license to the software in addition to other services. A CCA includes a software license if both of the following are true:
- Your institution has the contractual right to take possession of the software at any time during the hosting period without significant penalty (i.e., the monetary or nonmonetary penalty is not sufficiently significant to disincentivize your institution from taking possession of the software).
- It is feasible for your institution to either run the software on its own hardware or contract with a third party unrelated to the vendor to host the software.
A software license within a CCA should be accounted for as an asset. To the extent any or all of the software license fees are still outstanding, a liability is recognized on the acquisition date of the license.
If a hosting arrangement, or a portion of it, does not meet the software license criteria mentioned above, it is considered a service contract. Costs related to the contract should be capitalized or expensed following the same guidance previously discussed for internal use software.
Implementation costs that are capitalized as part of a hosting arrangement should be amortized over the term of the contract. This is defined as the fixed noncancelable term plus:
- Options to extend the arrangement (if reasonably certain to exercise).
- Options to terminate (if reasonably certain not to exercise that option).
- Options to extend (or not terminate) the arrangement that the vendor controls.
Management should periodically assess the estimated term and adjust the amount of amortization if necessary.
How Wipfli can help
Your management team should devote the necessary time to understanding all the accounting issues that come with a core system conversion – and Wipfli can help.
We take a customized approach to meeting your financial institution’s unique audit and accounting needs, applying our extensive industry experience to enhance your organization. Contact us today to learn how we can help you get more from your audit and accounting.
Sign up to receive more financial institutions content in your inbox, or continue reading:
