ARCHIVED -  Telecom Decision CRTC 91-14

Telecom Decision

Ottawa, 27 September 1991

Telecom Decision CRTC 91-14

ACCOUNTING FOR SWITCHING MACHINE SOFTWARE EXPENDITURES

I BACKGROUND

In British Columbia Telephone Company - 1987 Construction Program Review, Telecom Decision CRTC 88-12, 19 August 1988 (Decision 88-12), the Commission stated that it would review current accounting practices for software expenditures, focusing particularly on whether such expenditures should be capitalized or expensed. The Commission noted that software expenditures are an increasingly influential factor in the decision-making process, and that there are significant changes in service offerings and operational switching capabilities that are based on software rather than on hardware.

On 7 September 1988, the Commission issued Accounting for Switching Machine Software Expenditures, CRTC Telecom Public Notice 1988-44 (Public Notice 1988-44), initiating a review of switching machine software expenditures. Bell Canada (Bell), British Columbia Telephone Company (B.C. Tel), Northwestel Inc. (Northwestel), Teleglobe Canada Inc. (Teleglobe) and Unitel Communications Inc. (Unitel), formerly CNCP Telecommunications, (collectively, the carriers) were made parties to the proceeding.

In Public Notice 1988-44, the Commission directed the carriers to file the following:

(1) details of their present accounting procedures for switching machine software (both initial and subsequent expenditures);

(2) justification for these procedures; and

(3) comments on the appropriate treatment (including possible capitalization) of various switching machine software expenditures, particularly those incurred to provide extensions, new service offerings, or enhanced operational capabilities.

The procedures established in Public Notice 1988-44 provided for an interrogatory process and for the filing of comments by interested parties and of replies by the carriers. The Commission received comments from Consumers' Association of Canada (CAC), Government of British Columbia (BCG), Government of Ontario (Ontario) and Ontario Telephone Association (OTA).

The current generation of switching equipment is fundamentally different from its predecessors. Essentially,it consists of special purpose computers operating in conjunction with a range of peripheral equipment designed to do specific tasks. The computer uses a logical path rather than a metallic path for switching. Since a computer carries out the switching, software can completely control it. The function and uses of the equipment can thus be changed merely by modifying sequences of computer instructions 'programs'.

As with any complex computer system, errors are discovered in the programs during operation. These errors may initially be corrected with temporary ancillary programs. At some stage, it is preferable to rewrite the software, fixing all known errors, and reload the machine with revised software. Switch manufacturers do this on a systematic, periodic basis by issuing new software 'generics' or 'releases'.

A new software release entirely replaces what was previously in the machine. However, some of the new software will be exactly the same as the old, some will fix errors in or otherwise improve the old, and some will provide new or enhanced functional capability. The new software is in part a replica of the old and in part entirely new. It is almost impossible to distinguish these parts clearly.

Prior to this Decision, the Commission's only determination with respect to switching machine software expenditures was made in Bell Canada,General Increase in Rates, Telecom Decision CRTC 81-15, 28 September 1981 (Decision 81-15). Bell's practice prior to that proceeding was to expense most (if not all) software for switching machines, consistent with its practice for software for general purpose computers. In Decision 81-15, the Commission rejected Bell's practice of expensing initial application software costs for switching machines and directed that these costs be capitalized and depreciated over the service life of the switch itself.

Since Decision 81-15, other carriers have adopted approaches within the framework established for Bell. However, the carriers have not consistently interpreted the directive, the differences focusing primarily on what is encompassed by the term 'initial' software. While some carriers apply the term only to software purchased at the time of initial hardware installation, others have taken a broader view, including any software that provides new service offerings or enhances operational capabilities. In responding to the directions set out in Public Notice 1988-44, the carriers made distinctions between, among other things, 'basic' and 'application' software, 'initial' and 'subsequent' software, and 'operating' and 'application' software.

After the filing of submissions pursuant to Public Notice 1988-44, the Canadian Institute of Chartered Accountants (CICA) issued an Exposure Draft entitled 'Property, Plant and Equipment.' This, among otherthings, made recommendations on the accounting treatment of software. In light of the issuing of the CICA Exposure Draft and the diversity in the submissions filed in response to Public Notice 1988-44, the Commission, by letter dated 18 September 1989, directed the carriers to file additional financial information and sought comment on the Exposure Draft from parties to the proceeding. In addition, the Commission proposed definitions of basic, application and initial software, requesting comment on those definitions.

II PROPOSED DEFINITIONS

For 'basic' and 'application' software, the Commission proposed the following definitions, similar to those already in use:

(1) Basic Software consists of the set of programs required to operate and maintain the system processors of a specific switching machine. These programs are the same regardless of the particular applications for which the switching machine will be used.

(2) Application Software consists of the set of programs which operate by means of and under the control of the 'Basic' operating software. These programs provide operating and system maintenance instructions related to the specific application of a particular switching machine.

In the submissions filed pursuant to Public Notice 1988-44, the carriers diverged widely on what the term 'initial' software connotes. In its letter of 18 September, the Commission solicited comment on the following definition:

Initial software consists of software, either basic or application, furnished by either the switch manufacturer or a third party, that introduces features or additional capacity to the switching machine for which it is acquired.

The parties generally accepted the definitions proposed by the Commission for basic and application software. All parties had difficulty with the proposed definition of initial software. They noted that it included both basic and application software, and some found it confusing. Unitel submitted that the proposed definition was unnecessary. Both Unitel and B.C. Tel submitted that carriers could interpret the proposed definition differently, resulting in different cost allocations of the components of a software update. B.C. Tel added that this would reduce the consistency and comparability of carriers' financial results. B.C. Tel advanced an alternative, distinguishing between initial and revision (instead of subsequent) software. Northwestel proposed yet another alternative, differentiating initial software from upgrade and expansion software.

In light of the consensus on the distinction between basic and application software, the Commission adopts its proposed definitions, set out above, for these terms. In light of the criticism of its definition of 'initial' software, and the difficulties of attempting to resolve and employ definitions of 'initial', 'revision', 'upgrade' or 'expansion' software, the Commission will rely, for regulatory purposes, solely on the basic/application distinction.

III ACCOUNTING PRACTICES

A. CICA Proposed Accounting Recommendations

The CICA Exposure Draft defined property, plant and equipment as comprising both tangible and intangible assets. It stated that software should be considered an intangible asset and, as such, should be capitalized and amortized. The Draft defined 'amortization' as the rational and systematic allocation of the cost (less salvage value) of an asset over its estimated useful life, and 'useful life' as the estimate of either the period over which one can use an item of property, plant or equipment or the number of units that it can produce. The Draft stated that 'betterments' should also be capitalized, and defined betterments as those costs incurred to enhance
the service potential of an item of property, plant or equipment.

In January 1990, CICA issued a Re-exposure Draft. As the changes were primarily editorial, the Commission sought no further comment. CICA incorporated such recommendations into its Handbook in October 1990, after the record of this proceeding was complete. The terminology was changed and the material was rearranged. However, the recommended practices relevant to this Decision remained essentially unchanged.

B. Positions of the Carriers

1. General

All carriers agreed that basic software should be capitalized. The opinions on application software ranged from expensing all of it to capitalizing all of it. There were also diverse opinions on the appropriate method of amortization of capitalized software.

At present, the carriers that capitalize software purchased after the installation of collateral switching equipment associate an expected year of final retirement with the switch. They then depreciate the capitalized software cost over the expected remaining life of the switch.

2. Bell

At present, Bell capitalizes basic and application software purchasedfor the initial installation of a switching machine in the same account(s) as the hardware and depreciates it over the service life of the hardware. Bell expenses the cost of later (application) software using a maintenance code corresponding to the class of plant involved.

Bell maintained that CICA, by specifically including software as intangible property, intended to classify software as a capital asset with its own characteristics. Bell argued that switch hardware and switch software should be accounted for separately.

Bell submitted that basic software depends on the hardware features and generally lasts for the life of the hardware. Accordingly, it should continue to be capitalized and depreciated over the life of the hardware. Bell contended that the useful life of application software is very short and unpredictable, thus expensing it is essentially equivalent to amortizing it over its useful life. Therefore, expensing is the appropriate accounting treatment.

Bell also submitted that more extensive capitalization of application software would require the selection of an appropriate amortization period. Bell submitted that, should the Commission decide to adopt such a treatment, the amortization period should be unrelated to, and much shorter than, the useful life of the switch itself. Bell suggested an amortization period of three to five years.

3. B.C. Tel

At present, B.C. Tel capitalizes software purchased for the initial installation of a switching machine and expenses later (application) software purchases.

B.C. Tel submitted that revision software (software added after initial installation, that introduces new features or additional capacity) should be expensed. In theory, B.C. Tel agreed with the CICA Exposure Draft (which stated that betterments should be capitalized). However, on practical grounds, it considered the CICA proposed accounting recommendations inappropriate because the betterment and repair portions of software updates cannot be separately identified. Moreover, rapidly changing technology may render it impossible to determine the service life of an update.

B.C. Tel submitted that its present method of accounting for application software is appropriate and advanced various reasons for its retention. However, the company also set out a possible alternative treatment. The company suggested amortizing initial application software over the life of the switch and revision software over a much shorter period, for example, three years.

4. Northwestel

At present, Northwestel capitalizesall purchases of both basic and application software. Northwestel submitted that capitalization of all switching machine software is correct and in accord with the CICA Exposure Draft. The company expressed concerns about the volatility in its revenue requirement that would flow from expensing application software.

Northwestel also submitted that depreciating software and hardware at the same rate places too much future value on the software. Accordingly, it should be capitalized under a different asset code and depreciated according to its own equal life group. Noting the complexity in estimating service life, the company suggested possibly initially using the switching equipment depreciation rate.

5. Teleglobe

At present, Teleglobe capitalizes all software acquired with the first purchase of switching equipment and depreciates it over the expected service life of the hardware. The company expenses payments for the maintenance or update of software when it does not significantly increase the total volume of service. It capitalizes expenditures for software that, in its view, appreciably increases the traffic capacity, extends functional capability or greatly increases the operating efficiency of the existing fixed assets.

Teleglobe agreed theoretically with the CICA Exposure Draft, but pointedout a practical difficulty in consistently and accurately separating the betterment and repair components of updates. Teleglobe preferred to maintain its existing practices and to amortize the capitalized expenditures over three to five years.

6. Unitel

The record leaves some doubt about the present practice of Unitel. The company stated that it capitalizes operating software, whether purchased at the initial hardware installation or upgrades, and expenses customer-specific (application) software. However, it also stated that it budgets Batch Change Supplements (BCSs) as an expense in all cases.

Unitel suggested that its current practice logically separates a general asset from what is likely to have no future value to the company. Unitel stated that customer-specific software could be capitalized when it might remain unchanged for several years, but that future customer behaviour would be extremely difficult to predict.

Unitel supported CICA's classification of software as an intangible asset. The company submitted that software should consist of only two categories, i.e., 'basic' and 'application' (as defined by the Commission), which should have separate depreciation treatments. Software that is a total replacement should be capitalized and the old software removed from the books. The company submitted that the bettermentrules of the CICA Exposure Draft should apply to software enhancements.

C. Comments of Interested Parties

BCG supported the CICA recommendations. BCG submitted that any software that underlies the switching function and is expected to operate as long as the hardware should be capitalized and depreciated over the life of the switch. BCG also submitted that application software with an expected life less than that of the hardware should be treated separately for accounting purposes and amortized over a period consistent with the anticipated service life.

'Incremental' application software that adds new features or expands capacity should be capitalized and amortized over the remaining switch life. Costs associated with software repair and maintenance should be separated and expensed. If this is not feasible, the entire cost of the software upgrade should be capitalized and amortized over the remaining switch life. BCG also submitted that, if entire software modules must be replaced at known intervals, the amortization period should be consistent with those intervals.

Ontario contended that one should base the appropriate accounting treatment on the expected life of an asset. An asset that will provide useful service for more than one year should be capitalized. Otherwise, itshould be expensed in the year of purchase. According to Ontario, basic software should clearly be capitalized. However, because many different functions are performed via application software, different types of application software could have different useful lives.

CAC agreed with the practice of capitalizing software acquired with a switching machine and depreciating the software over the life of the hardware. CAC submitted that software employed to increase switch capacity should be capitalized and recovered over the remaining life of the switch. Application software that introduces services or enhances operational features should be capitalized and recovered over five years.

OTA supported Bell's position that it would be appropriate to expense all application software.

D. Reply Comments

Bell disputed the proposition that assets having a useful life greater than one year should be capitalized. Bell argued that, although this principle is usually employed and is appropriate for physical property, it is not necessarily appropriate for intangible or intellectual property with unpredictable life. The company again contended that expensing expenditures for such property is appropriate and generally accepted accounting practice, even if it provides useful service for more than one year. On similar grounds, Bell disputed the capitalization criteria suggested by BCG.

Bell also disputed CAC's submission that initial application software and application software to extend capacity should be capitalized and recovered over the life of the hardware. Bell submitted that software life and hardware life are unrelated. Bell noted the five-year amortization period suggested by CAC for application software that introduces new services or enhances operational features. Bell submitted that CAC's choice of such a period was purely arbitrary.

B.C. Tel reiterated its submission that revision software should be expensed. Alternatively, to the extent that enhancements or betterments can be identified, they should be capitalized and amortized over the useful life of the software.

Northwestel, like B.C. Tel, anticipated problems in distinguishing betterments and repairs. The company preferred a simple dichotomy (i.e., either initial and subsequent software, or basic and application software). Northwestel agreed with other carriers that basic software should be amortized over the life of the switch and that the useful life of application software is unpredictable. The company would prefer a five-year amortization period for application software.

IV SOFTWARE EXPENDITURE LEVELS

The carriers provided information on the purchase cost of both hardware and software in new digital switching installations. The data exhibited a wide variation in the ratio of software to hardware: from 9.0% (B.C. Tel) to 108.8% (Unitel). This is due in part to different carrier definitions of the software component of new digital switches and remote units. These data and other information on particular switch acquisitions suggest that, for new units, the software cost would be roughly one-quarter to one-half the hardware cost.

The carriers also provided estimates of their first and subsequent software expenditures (per switch) over the life of the switch. The forecasts for subsequent software costs usually range between one-half and the full original cost.

V FINANCIAL IMPLICATIONS

In its letter of 18 September 1989, the Commission asked carriers to estimate the additional costs necessary to maintain records and carry out depreciation studies of software if all switching machine software were capitalized and either:

(1) treated as a separate depreciation category; or

(2) included in the same category as the hardware.

Under both scenarios, the start-up costs and additional annual costs appear insignificant for B.C. Tel, Northwestel, Teleglobe and Unitel. Bell estimated much higher start-up costs for either scenario than did the other carriers. Bell uses mass property depreciation for the DMS family of switches and therefore does not associate a remaining life with individual switches. Amortizing the software over a suitable period, in lieu of depreciation, would probably largely eliminate Bell's significant start-up costs.

During the phase-in period, the revenue requirements of all carriers would alter as a result of any software accounting changes. The greatest effect would ensue from shifting from expensing to capitalizing or vice-versa. For large companies, after the phase-in period, there would probably be little difference in revenue requirement whether software is capitalized or expensed. A difference might occur if a carrier introduced, via a major new software package, a new service or operational change throughout the network. For a medium sized or small carrier, capitalizing would smooth software-related expenses.

VI CONCLUSIONS

The Commission considers it appropriate, in prescribing the accounting treatment for switching machine software, to take intoaccount the treatment adopted by CICA (which, as noted above, involved no substantive changes over the recommendations considered in this proceeding). The Commission does not consider it necessary to take into account tax policy on software, since capital expenditures are normally treated differently for accounting and tax purposes.

CICA treats software as intangible property and, thus, as a capital asset. The Commission notes that the practices of Bell and B.C. Tel for basic software and the first load application software comply with CICA's treatment. However, their practice of expensing other application software differs. CICA envisions expensing only the repair portion of the update and capitalizing the betterment portion. All parties acknowledged that new software releases customarily include both betterments and repairs that are difficult to separate with accuracy and consistency.

The Commission agrees with Bell that basic software depends on the hardware features, is independent of applications, and usually lasts as long as the hardware. Noting the general consensus with respect to basic software, which reflects current practice and conforms to the treatment proposed and adopted by CICA, the Commission directs the carriers party to this proceeding to capitalize basic software for switching machines and to amortize it using the life characteristics of the associated switching machine hardware.

In the case of application software, although some machines typically receive annual updates, useful life is not necessarily one year or less. While the life of application software need not relate directly to the hardware, most software would be useful for more than one year.

Application software has future use only on the switch where it is installed. However, on that particular switch, it has future revenue-generating capability. Although a software update may not increase the sale value of a switch, when that update adds enhancements and features, the revenue-generating capability of the switch increases, as does its value as a revenue-producing asset.

For large companies, software update expenditures may be evenly spread from year to year. In this case, expensing produces little variance in the revenue requirement. For smaller companies, software acquisition exhibits much more lumpiness. Capitalization would tend to smooth the revenue requirement.

In light of the above, the Commission finds that capitalizing and amortizing application software would provide a better match between cost recovery and subscriber benefit, would not place an undue burden on any carrier, and would be consistent with CICA's general approach.

As indicated by the record of the proceeding, the useful life of application software varies considerably, is often difficult to determine, and may or may not be related to the useful life of the associated hardware. Several parties noted the difficulty of attempting to determine the appropriate amortization period or periods for application software. Two approaches have been suggested to address this problem. One is to use a single arbitrary period that in some way approximates software life. The other is to employ the remaining life of the associated hardware, recognizing that the software and hardware jointly provide switching capability.

Having examined the two approaches, the Commission considers it appropriate to select a single period over which to amortize expenditures for application software. Such an approach is simpler, less costly and as likely as the alternative to yield overall results that are satisfactory. Based on the record of the proceeding, the Commission considers a five-year period a generally acceptable proxy for useful life that, at the same time, is sufficient to smooth the revenue requirement. Accordingly, the Commission directs the carriers party to this proceeding, commencing 1 January 1992, to capitalize application software acquired after that date and to amortize it over a five-year period.

The Commission notes that the portions of an update that replaceexisting switch software are often covered under warranty. In effect, only added features are invoiced. At present, those carriers with extended warranty coverage expense the associated cost. The Commission considers this treatment appropriate, and directs that the carriers continue it.

The Commission does not, at present, have up-to-date information as to how the above directives will affect the carriers' revenue requirement, nor does it have information as to the effect of changing the amortization period for the existing capital investment. Therefore, prior to ruling with respect to the amortization of the current application software investment, the Commission directs that, by 8 November 1991, carriers party to this proceeding estimate and report (providing details of the calculations) the revenue requirement change, for each of the years 1992 to 1996, resulting from implementing the above directives and from amortizing the embedded investment in application software:

(1) over five years;
(2) over ten years; or
(3) according to the company's current schedule.

The carriers are also to indicate, with supporting detailed calculations, their preferred method of amortizing existing investment.

The Commission is of the opinion that the directives noted above are likely appropriate for other carriers under its jurisdiction, i.e., AGT Limited,The Island Telephone Company Limited, Maritime Telegraph and Telephone Company Limited, The New Brunswick Telephone Company Limited and Newfoundland Telephone Company Limited. Therefore, these carriers are to file, by 8 November 1991, comments on the feasibility and desirability of capitalizing application software and amortizing it over five years. In addition, the carriers are to estimate and report (providing details of the calculations) the revenue requirement change, for each of the years from 1992 to 1996, that would result from adopting such an approach and from amortizing the embedded investment in application software:

(1) over five years;
(2) over ten years; or
(3) according to the company's current schedule.

The carriers are to indicate, with supporting detailed calculations, their preferred method of amortizing the existing investment, should the Commission direct them to do so.

Allan J. Darling
Secretary General