Technical Debt on the Balance Sheet

My recent article on the high cost of “low cost” software seems to have struck a nerve with lots of views, comments, likes, shares, etc. A lot of software development professionals feel the weight daily of the tendency to chase the lowest price of software development and have added to the conversation I started last week. Below are some of the comments:

There is always a price for “free.”

In the end, it’s all about understanding the nature of software development in order to make wise decisions.

As the saying goes: “if you believe a senior developer is expensive, wait till you hire a Junior”.

Another aspect of poorly written code is the inefficient use of hardware which it runs on … leading to negative user experience .. Resulting in losing $$ in terms of user productivity .. Adding to the higher cost !!

My unscientific guess is corporate America is wasting billions each year on “low cost software “.

It’s funny how there never seems to be enough time to do it right, but always enough time to do it twice.

The technical debt gets worse when you add an army of developers to it.

The old saying “you get what you pay for” rings true.

Perhaps the most interesting comment came from Jason Ross who stated:

It’s often the case that people get “value” and “cost” confused. Technical debt is a very debt that must eventually get serviced. In the same manner that debt service kills cash flow and becomes a drag on the balance sheet, so does technical debt deprive an the ability to deliver new features and effectively update the code base as new technologies arrive that could be leveraged. In the long run, the maintenance and upkeep costs becomes the dominant factors in many things, and especially in software, they are often entirely neglected as factors.

Balance SheetWhen I read his comment and saw his mention of “a drag on the balance sheet” it reminded me of an article I had read a few years back from Israel Gat for his blog The Agile Executive titled Technical Debt on Your Balance Sheet

Israel’s assertion is now that there are ways to rather easily assess technical debt (like SonarQube with SQALE plugin), technical debt could (and should) be added to a company’s balance sheet. I applaud and support his efforts.

Unfortunately, it appears that any efforts to include technical debt on a company balance sheet might run into some accounting industry standards that would make this not currently possible. In his post, Clear Costs and Technical Debt, Trent opines

Accounting standards don’t allow provisions or liabilities to be shown for “not performing enough maintenance” or similar intangibles. There needs to be a present obligation before a liability is incurred and a present obligation is only usually formed through a contract.

In his scenario, financial wizards will chalk up the lower cost of software development as a savings.

The accountants will note a(n)… asset on the books, congratulate themselves for saving … capex and chalk up the increased opex of maintenance as the cost of doing business.

AccountingMy guess is this is precisely what happens now. If Trent is correct, then the issue facing companies developing software is that current accounting practices are inadequate and need to be modified. Technical Debt can be measured and tracked and is a very real liability.

The question remains: can there be a new GAAP around technical debt or can an existing GAAP be instructive? While I am not a CPA, I have done work in accounting in the past so I know “enough to be dangerous.” My line of thought is that technical debt probably resembles something that currently exists in GAAP. After doing some research I think that maybe GAAP around warranties may prove helpful. In reading about warranties in an article GAAP Accounting for Product Recalls. I noticed some similarities:

Product warranties present manufacturers with a bit of a conundrum. …The manufacturer is actually responsible for the product for the length of the warranty. In accrual accounting, the finality of the transaction does not occur until the period of responsibility ends. However, warranties … present a bit of an exception to the rule. (Emphasis mine)

Notice how, like technical debt and the Total Cost of Ownership (TOC) of software, the complete transaction is not final until the period of responsibility ends. I can see that the life cycle of software (and liability of technical debt – present or future) is like the life cycle of a product with a warranty attached. Even I can see how warranties could cause accounting headaches. However,

Rather than being on the hook for the cost of the product for the entire life of the product or throughout the product’s warranty period, manufacturers can instead follow the generally accepted accounting principles regarding products under warranty. … Under GAAP, product warranties and recalls can be reasonably accounted for with the initial sale of the product by estimating the potential warranty expense of a return or recall.

I can reasonable see how it might be possible to substitute an estimate of Technical Debt liability for the similar liability of estimated warranty expense. For example, with each release we classify software as a capital expense (CapEx). At this point we could also include on the balance sheet an estimation of technical debt as a long-term liability.

In the case of warranties, the actual accounting mechanism under GAAP is done by

 …making two separate entries, one a debit and the other a credit for the same amount. These are entered into the ledger as a warranty expense and a separate entry as an allowance for warranty costs.

What is to stop a company for entering two separate entries for technical debt – one a debit as technical debt expense and the other a credit under allowance for technical debt? I certainly see this as in the realm of possibility. This way GAAP can be followed AND technical debt can be raised to true financial visibility. It is this visibility that will allow companies to begin seeing the true total cost and guard against the high cost of “low cost” software development.

2 Replies to “Technical Debt on the Balance Sheet”

  1. Intellectual property in general is not well covered by GAAP. Patents and some IP can be valued as an asset but most designs and know-how are not on included as assets on the balance sheet.
    They are however implied by the difference between a companies net asset value and the market value of the company. This is the effective undeclared intangible assets that represents the financial markets view of the value of such things as corporate brand, management, designs and organizational know how and of course future profit. This is often called goodwill.

    Technical debt is effectively a negative intangible asset.

    Interestingly when a company buys another company it pays real money for these undeclared assets and therefore can now place this value on the balance sheet as acquired goodwill.

    Clearly the financial market has very little sight of technical debt (most company executives do not understand it) and therefore they are unable to make any meaningful assessment of its impact on the company.

    Companies with a lot of dependency on software really need to be focussing on this topic. as left un-managed it could lead to significant loss of share price when the weight of the debt degrades a companies competitiveness.

    1. Awesome comments Larry. I was hoping someone like yourself, with an obviously superior understanding of accounting, would weigh in. My initial blog was like a question. Your comment was an excellent answer to that question.

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