Whether you are a manufacturer looking to implement a new enterprise resource planning (ERP) system, a distributor upgrading your Warehouse Management System (WMS), or you are in the business of developing software to be sold, you have likely wrestled with the question of which software development costs should be capitalized and which costs should be expensed. Finding the right answer in the accounting standards first depends on whether the software is developed for internal use or the software is going to be sold. While these can be confusing standards to navigate, the Financial Accounting Standards Board (FASB) is currently working on updating these standards which will be a welcomed change.
Internal-Use Software (ASC 350, Intangibles)
Capitalizing internal-use software is covered in section 350-40 of the Accounting Standards Codification (ASC), which splits the software development process into three stages as shown below.
|Capitalize||• Internal & external costs to develop software||• Upgrades that add new functionality|
|Expense||• Vendor demonstrations
• Determining performance requirements
|• Training costs
• Data conversion costs
|• Training costs
• Maintenance costs
Beyond identifying the correct stage of development, accounting for internal-use software has other complexities such as tracking payroll and benefits to be capitalized, identifying which travel expenses need to be capitalized, and calculating interest to be capitalized.
Software to be Sold, Leased, or Marketed (ASC 985, Software)
Accounting for software to be sold, leased, or marketed has its own complexities. The accounting standards for software development costs have remained largely unchanged over the last 25 years despite significant changes in the software industry not simply in terms of products, but more importantly in terms of the process of developing software. Current guidance on accounting for software to be sold assumes the waterfall model of software development, which methodically moves from one phase to the next in a linear direction with more defined criteria separating each phase. Today, agile software development has taken over which is a more cyclical process that does not have a clean break from one phase to the next. This process change has resulted in companies trying to fit the square peg of agile software development into the round hole of generally accepted accounting principles as it relates to accounting for software development costs.
Change is Coming
The good news is that the FASB is aware of this disconnect and put it on their technical agenda. While they’re still in initial deliberations, the Private Company Council’s December 16, 2022 meeting showed a glimpse of a few of the possible outcomes. The following four models were discussed:
- Capitalize Initial Development Model – “Capitalize all direct software development costs from the point at which it is probable that the software project will be completed and the software will be used to perform the function intended until the software is substantially complete and ready for its intended use.” “Ongoing maintenance costs would be expensed, while enhancements would be capitalized.”
- Capitalize Ongoing Development Model – “Capitalize all direct software development costs from the point at which it is probable that the software project will be completed and the software will be used to perform the function intended until the software is impaired or abandoned. Under this model, an entity would not need to distinguish between enhancements and maintenance because all direct software development costs would be capitalized.”
- Expense All Model – “Expense all software development costs as incurred as R&D.”
- Dual Model – Internal-use software would use one of the Capitalization Models, and software to be sold would use the Expense All Model.
Lastly, there is a tax update on the treatment of software development costs. For all tax years starting after December 31, 2021, software development expenses will no longer be deductible in full in the year paid or incurred. Rather, all new software development expenses will be capitalized and amortized over 5 years for tax purposes. There is no new tax treatment of acquired or licensed software, rather these changes only apply to software development costs.