Software development has become a strategic imperative for companies seeking to maintain a competitive advantage. However, technological advancements come with significant costs, which raises the question of how companies should account for the costs incurred to develop their software solutions; should the costs be capitalized or expensed when incurred?
Current Guidance Has Challenges
Under the existing Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) framework, companies evaluate the nature of software development projects to make this determination. The accounting guidance lies in the following Subtopics:
- ASC 985-20, Software – Costs of Software to Be Sold, Leased, or Marketed - applies to costs that are incurred when developing software that will be sold, leased or otherwise marketed, and
- ASC 350-40, Intangibles – Goodwill and Other – Internal-Use Software - applies to costs incurred in developing software that is used to meet a company’s internal needs or to provide services to its customers, for example, SaaS.
Application of this guidance can be challenging. The pace of technological advancement adds complexity in accounting for different software development scenarios, and we believe the FASB is justified in exploring improvements to the current guidance applicable to these costs.
The Scoping Conundrum
The first challenge companies often encounter is determining which of the two Subtopics should be applied. The answer depends on a potentially complex evaluation of whether a software license will be transferred to a customer or is practically transferrable. It wasn’t long ago that most software was delivered on a disk or downloaded as a set of digital files, making this assessment rather straightforward. Today, many software products are offered on a subscription basis or sold with a license element as well as a SaaS element, further complicating this assessment. Once the appropriate Subtopic is identified, companies apply criteria specific to either Subtopic to determine which costs to capitalize.
To Capitalize or Not to Capitalize
Capitalization under ASC 985-20 is required once “technological feasibility” is achieved. According to the standard, technological feasibility is achieved “when the entity has completed all planning, designing, coding and testing” necessary to determine that the product will meet its design specifications.
On the other hand, Subtopic 350-40 states capitalization of costs should begin after two criteria have been met: (1) the preliminary stage of the development process has been completed, and (2) company management authorizes the software project and commits to funding. The criteria for capitalizing those development costs typically have a broader scope compared to the criteria under Subtopic 985-20, creating the potential for divergence in the costs included in capitalized balances.
Interpreting Software Development Efforts
The difference in how the criterion for capitalization is defined between the two subtopics inevitably creates challenges for investors trying to make meaningful comparisons when evaluating development-based performance metrics between entities with differing software solutions. The question being addressed by the FASB is whether there should be a difference in accounting for development costs incurred for a software solution delivered via a license versus a solution used internally or hosted in the cloud and sold as a service.
Regardless, it can be challenging for companies to track and properly identify the costs that are required to be capitalized. Again, the pace of technology change has side-stepped the more linear approaches to capitalize on costs predicated by the subtopics. Companies will often need to implement extensive and scalable internal controls to properly identify software development costs.
Looking to the Future
In response to the rapid changes in technology, the FASB added a project to its agenda to modernize the accounting for software costs and enhance related disclosures.
The FASB has met on various occasions during 2023 and reached the following tentative decisions:
Starting and Ending Thresholds for Capitalization
The FASB expressed support for a model that would require capitalization of software costs to begin at the point when the software project is probable of being completed, supported by management’s commitment, identification of core capabilities and the absence of unresolved high-risk development issues. Entities would take past experiences for similar types of software into account. This evaluation should take place at the level of a software project, which may include various activities.
The Board decided to set the ending threshold for capitalization of software costs when both the software project is substantially complete, and the software is placed into service.
Subsequent Activities
The Board tentatively decided:
- When unclear if subsequent activities are a new software project under the unit of account definition, an entity would evaluate the direction and level of dependency between the existing software and the new software.
- To define only the activities that would be subject to capitalization (enhancements) and that all other costs would be expensed as incurred.
- To define enhancements as significant activities that add new functionality and significance would be evaluated based on the level of effort.
The FASB is planning to perform targeted investor outreach and explore potential improvements to existing guidance when applied to an agile software development environment.
Next Steps
Until the FASB project to enhance the guidance applicable to software development comes to fruition, companies dealing with software development will be challenged in scoping and applying the relevant guidance from the codification. We continue to monitor the progress of FASB to improve and modernize accounting for software development costs. If you have any questions or need assistance on this topic, connect with a team member today.
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