Question 2 - Capitalization of software development costs

NFT Heaven provides software that allows consumer products companies to create non-fungible tokens for their physical consumer products.

The software is sold as a service (SaaS), and companies are charged on a monthly basis based on the number of users within their organizations. Revenue recognition occurs over time as the software is being used.

On January 1st, 2022, NFT Heaven started researching how to develop its first software product which it will call NFTWonder.

The company spent the first 3 months of the year (Jan, Feb, March of 2022) on initial R&D and pre-development for NFT Wonder, spending $20K a month on software developers.

Starting at the beginning of April, NFT Heaven began formal development of the software, and it plans to launch the software at the beginning of next year, on January 1st 2023.

Throughout 2022, NFT Heaven continued to spend $20K a month on software developers to develop NFTWonder. Starting on Jan 1st, 2023, the company ramps up spending on software development costs to $30K a month throughout 2023, but as of the end of 2023, the company stops spending money on developers for this software product.

Below are the expected revenues from NFTWonder:

Assume that the software (NFTWonder) launched on Jan 1st, 2023, and that the company was immediately able to sell 10,000 users in the first month, each paying $10 a month for the software. Assume that these 10,000 users are the only new users that are added in 2023. Also assume that 100% of the users will be retained as customers for the entire 12 months. These sales were consistent with the forecasts that the company had made.

On Jan 1st, 2024, assume the company will add 2,000 more customers and retain 100% of the original 10,000 customers. It will also retain 100% of the new customers throughout 2024. These additional sales were consistent with company forecasts.

For 2025, assume the company is forecasting it will retain 100% of its customers that it had in 2024, but not add any new customers. After 2025, the company expects to retire the product and not generate any future revenue from it.

Below are some notes on the accounting treatment for revenue recognition and software development costs under Generally Accepted Accounting Principles (GAAP):

Revenue recognition (GAAP rules). o Software sold as a Service. A company that sells "Software as a Service" (SaaS) recognizes revenue over time as the paying users are accessing the software. For accounting purposes, this is considered software that a customer has a "right to access".

o Software sold as a product. A company that sells software as a product is considered to have licensed that software to a customer at a specific point in time, giving the customers a "right to use" the software. The revenue is recognized at the point in time in which the software license is bought by the customer.

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Software development costs (GAAP rules). o Software sold as a Service (SaaS). A company that sells SaaS is required to capitalize software development costs once the company starts formal software development. Prior to starting formal development of the software (during an R&D phase), any software development costs are expensed.

o Software sold as a product. A company that sells software as a product is required to capitalize software development costs once the company establishes "technological feasibility" for the product. Prior to achieving "technological feasibility", any software development costs are expensed.

o Capitalization and amortization of software development costs. For this problem, assume that companies that capitalize software development costs will capitalize costs in each specific year that costs are incurred. Once the software application is generally released, the development costs are amortized and included as an expense.

Each year, the amortization of the capitalized costs should be equal to the greater of:

(1) The ratio of current product revenue to total product expected revenue, or

(2) The amount calculated on a straight-line method over the remaining economic life of the product

The above calculation should be done separately for each yearly tranche of software development costs that are amortized.

Important: Assume any software development costs that are capitalized in a specific year, are amortized starting in the following year. Please answer the following questions:

1) What is the total amount of software development costs that are capitalized during 2022?

2) What is the total amount of software development costs that will be capitalized during 2023?

3) What was the total amount of software development costs that will be capitalized during 2024?

4) How much software development costs should be amortized as an expense during 2023? Please show your calculations for this. [HINT: This would include only the amortization of software development costs that were capitalized in 2022]

5) How much software development costs should be amortized as an expense during 2024? Please show your calculations for this. [HINT: This would include amortization of software development costs that were capitalized in both 2022 and 2023]

6) Instead of capitalizing the software development costs, assume that the company incorrectly ended up expensing all the software development costs as incurred.

(i) How would that impact income in 2023? Ignore any impact of taxes.

(ii) How would that impact income in 2024? Ignore any impact of taxes.