SOP 98-1: Accounting for Internal-Use Software Costs
Gain insight into accounting guidance for internal-use software, detailing how costs are classified as a capital asset or an expense over a project's lifecycle.
Statement of Position 98-1 was issued by the American Institute of Certified Public Accountants (AICPA) to standardize how companies handle costs for computer software developed for their own use. The guidance determines when these costs should be recorded as an asset versus when they are treated as an expense. These accounting rules, originally known as SOP 98-1, are now part of the Financial Accounting Standards Board’s (FASB) official framework and are found within the Accounting Standards Codification (ASC) Topic 350-40.
Identifying Internal-Use Software Costs
The guidance applies to software that is acquired, developed, or modified exclusively for an organization’s internal operational needs. During the software’s development, the company must have no substantive plan to sell, lease, or otherwise market it to outside parties. If such a plan exists, different accounting standards apply. Examples of internal-use software include custom CRM platforms, proprietary inventory tracking systems, or internal human resources portals.
The rules do not apply to software developed with the intention of being sold or leased, which is accounted for under ASC 985-20. Costs for software intended for research and development (R&D) also fall under separate R&D accounting guidance until technological feasibility is established.
Certain activities are also excluded from capitalization even if related to an internal-use software project. Costs for converting old data for use in a new system are expensed as incurred. The costs associated with training employees on the new software are also always treated as an expense.
Accounting Treatment by Development Stage
The accounting for internal-use software costs is dictated by the project’s development stage. The framework has three phases, each with its own rules for whether costs are expensed or capitalized as an asset.
The first phase is the Preliminary Project Stage, involving conceptual work done before a project is formally approved. Activities in this stage include:
- Brainstorming
- Evaluating different technological solutions
- Exploring vendor packages
- Making the final selection
All costs incurred during this exploratory phase, such as salaries for evaluation meetings or consultant fees, are expensed as incurred. Capitalization is prohibited until the project receives formal management commitment.
Once management authorizes funding, the project enters the Application Development Stage, where the software is designed, coded, installed, and tested. Direct costs incurred during this stage are capitalized and recorded as an intangible asset. Capitalizable costs include payments to third-party developers, payroll for employees directly involved in development, and interest costs from debt used to finance the project.
General and administrative overhead costs must be expensed as incurred, even if they support the development team. The capitalization period ends once all substantial testing is complete and the software is ready for its intended use.
The final phase is the Post-Implementation and Operation Stage, which begins when the software is placed into service. All costs from this point forward, such as maintenance, bug fixes, and help desk support, are expensed as they happen. If a company performs a significant upgrade that adds new functionality, those enhancement costs are re-evaluated using the three-stage model to determine if they qualify for capitalization.
Post-Development Accounting Treatment
After the software is placed in service, the capitalized development costs are treated as a long-lived intangible asset. The total capitalized cost is not immediately charged against income but is recognized systematically over the period it is expected to benefit the company.
The capitalized software cost must be amortized on a straight-line basis unless another method better represents the pattern of its use. Amortization begins once the software is ready for its intended function. The amortization period is the software’s estimated useful life, which requires considering factors like technological obsolescence and the company’s future plans for the software.
Companies must also periodically evaluate the capitalized software asset for impairment. An impairment test is necessary if events suggest the asset’s carrying amount may not be recoverable, such as a decision to abandon the software for a newer system. If the asset is impaired, its value must be written down to its current fair value, resulting in an immediate expense for the write-down amount.
Application to Cloud Computing Arrangements
The original guidance did not address cloud-based Software-as-a-Service (SaaS) models where a company does not own the software license. To resolve this, the FASB issued Accounting Standards Update (ASU) 2018-15. This update addresses a customer’s accounting for implementation costs in a cloud computing arrangement that is a service contract.
This update aligns the accounting for implementation costs with the principles for internal-use software. While recurring SaaS subscription fees are expensed, ASU 2018-15 allows companies to capitalize certain implementation costs. Eligible costs include expenses for software configuration, testing, and data conversion needed to make the cloud service operational.
The capitalized implementation costs are recorded as an asset and amortized over the term of the hosting arrangement. This term includes the noncancellable contract period plus any renewal periods that are reasonably certain to be exercised. These capitalized costs must also be tested for impairment, similar to traditional internal-use software assets.