ASC 350-40: Capitalizing Internal-Use Software Costs
Understand the accounting framework that governs how a company's investment in its own software is reflected in its financial statements over time.
Accounting Standards Codification (ASC) 350-40 provides the guidance under U.S. Generally Accepted Accounting Principles (GAAP) for costs associated with computer software developed or acquired for a company’s own use. It dictates which costs should be treated as a long-term asset on the balance sheet through capitalization, and which should be recorded as an expense on the income statement when incurred.
Capitalizing costs can defer their full impact on a company’s reported net income, while expensing them reduces profitability immediately. ASC 350-40 creates a structured approach to this decision-making process, ensuring that financial reporting for these investments is comparable across companies and industries.
Scope of Internal-Use Software
ASC 350-40 governs software that is acquired, developed, or modified solely to meet an entity’s internal needs, meaning it is not intended for external marketing, selling, or leasing. For instance, a custom-built system for managing internal payroll and human resources or a proprietary inventory tracking platform falls within this standard.
The guidance distinguishes between internal-use software and software developed to be marketed externally. Software created to be sold or licensed to customers is accounted for under a different standard, ASC 985-20, which has its own rules for capitalization. A company’s intent during the development phase is a primary consideration.
For example, a bank developing a new online banking platform for its customers is creating an internal-use application falling under ASC 350-40. Conversely, a technology company that builds a project management tool to sell subscriptions to the public would follow the guidance in ASC 985-20. The determination hinges on whether the software is a tool for internal operations or a product for external sale.
Capitalization Criteria and an Evolving Framework
The accounting treatment of software development costs under ASC 350-40 has traditionally been tied to a three-stage development lifecycle. The Financial Accounting Standards Board (FASB) is finalizing a new standard, expected in 2025, that will eliminate this prescriptive model to better align with modern software development methodologies, such as Agile. The historical model provides context for current accounting practices and divides the process into three phases.
The first phase is the Preliminary Project Stage. During this period, activities focus on conceptualization and planning, including evaluating technological alternatives, determining system requirements, and making a final selection on the path forward. All costs incurred during this exploratory stage must be expensed as they are incurred.
The second phase is the Application Development Stage. This is the only phase where capitalization is permitted. Activities in this stage include the design of the chosen software path, coding, installation of hardware, and all testing activities. Capitalization of eligible costs continues until the software is substantially complete and ready for its intended use.
The final phase is the Post-Implementation/Operation Stage. This stage commences once the software is placed into service. Costs incurred during this period are related to the ongoing use and maintenance of the system, such as user support and routine maintenance activities. All of these operational costs are expensed as they are incurred, as they do not add new functionality to the software asset.
Identifying Capitalizable vs. Expensable Costs
During the application development stage, it is important to distinguish between the specific types of costs that can be capitalized and those that must be expensed. Not all expenditures incurred during this phase qualify for capitalization.
Costs that are eligible for capitalization are those directly associated with developing the software. This includes payroll and related benefits for employees who spend time directly on the project, such as software engineers and project managers. It also includes external direct costs for materials and services, such as fees paid to third-party consultants for development work and the cost of any software licenses purchased for the project.
Conversely, several types of costs must be expensed even if they occur during the application development stage. General and administrative overhead costs are not considered direct costs and must be expensed. Data conversion activities, like cleaning or purging old data and converting it to the new system’s format, are expensed as incurred. Employee training costs are also always expensed, as they relate to preparing the workforce to use the software rather than building the software itself.
Post-Capitalization Accounting Treatment
After the software is placed in service and the eligible development costs have been capitalized as an intangible asset, the accounting process continues through amortization and periodic impairment reviews.
The capitalized software cost must be amortized, which is the process of allocating its cost over its useful life. The straight-line method of amortization is most common, unless another method is more representative of the software’s usage pattern. Determining the estimated useful life requires consideration of factors like obsolescence, technological advancements, and competition. Amortization begins when the software is ready for its intended use.
The capitalized asset must also be regularly evaluated for impairment. An impairment loss must be recognized if circumstances indicate that the carrying amount of the asset may not be recoverable. This could happen if the software is abandoned before implementation, if the company decides to switch to a different system, or if the business segment that uses the software becomes unprofitable.
Application to Cloud Computing Arrangements
The principles of ASC 350-40 have been adapted to address the prevalence of cloud computing, particularly Software as a Service (SaaS) models. While fees for using a cloud-based service are expensed as a service contract, the guidance provides a framework for the implementation costs associated with these arrangements.
Under the current guidance, a customer’s costs to implement a cloud computing arrangement are analyzed using the same stage-based model as traditional internal-use software. As the underlying guidance for internal-use software is updated, the criteria for capitalizing these implementation costs will also evolve. For now, capitalizable implementation costs might include configuring the cloud software, performing customizations, and testing the setup.
The capitalized costs are recorded as a prepaid asset and amortized over the term of the hosting arrangement. The company is not capitalizing the cloud software itself, but rather the specific, direct costs incurred to implement it. Other costs, such as data conversion and training related to the cloud service, are expensed as incurred.