SOP 98-1 Is Superseded: What Replaced This Guidance?
SOP 98-1's principles have evolved. Learn the current financial reporting for software costs, from traditional development to modern service-based arrangements.
For many years, companies relied on the Statement of Position (SOP) 98-1, Accounting for the Costs of Computer Software Developed or Obtained for Internal Use, for guidance on software expenditures. This standard has been superseded, with its principles integrated into the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC).
The codification is the source for U.S. Generally Accepted Accounting Principles (GAAP). The guidance for internal-use software now resides within ASC 350-40, Intangibles—Goodwill and Other—Internal-Use Software. The FASB has issued additional Accounting Standards Updates (ASUs) to amend this guidance, and ASC 350-40 with its updates are the current authoritative standards.
The Current Standard for Internal-Use Software
Guidance for software developed to meet an entity’s internal needs is in ASC 350-40. This standard divides a software project into three phases to determine if costs should be expensed on the income statement or capitalized as an asset on the balance sheet. This approach provides a consistent method for accounting for these investments.
The initial phase is the preliminary project stage, during which all costs are expensed as they are incurred. Activities in this stage include the conceptual formulation of the project, evaluating technological alternatives, determining performance requirements, and selecting a vendor. Any spending before management commits to and authorizes the project is expensed.
Once the preliminary stage is complete, the application development stage begins, and capitalization of certain costs is appropriate. Capitalizable costs include direct external costs for materials and services, such as fees paid to third-party developers; payroll costs for employees directly involved in the project; and interest costs incurred during development.
Not all costs during the application development stage are capitalized. Expenses that must be recognized as incurred include data conversion activities, employee training, and general and administrative overhead not directly attributable to the project. An exception exists for costs to develop software that allows for access to or conversion of old data by the new software.
The final phase is the post-implementation-operation stage, which begins once the software is substantially complete and ready for use after all testing is finished. Costs incurred during this stage, such as maintenance and help desk support, are expensed as incurred. An exception exists for costs that add new functionality, as these upgrades may qualify for capitalization if they meet the criteria of the application development stage.
Accounting for Cloud Computing Arrangements
The rise of cloud-based software as a service (SaaS) created accounting questions not addressed by the original guidance. In response, the FASB issued Accounting Standards Update (ASU) 2018-15 to address a customer’s accounting for implementation costs in a cloud computing arrangement that is a service contract. This update clarifies how to treat costs when a company pays a fee to access vendor-hosted software instead of owning a license.
A determination under this guidance is whether the arrangement includes a software license or is solely a service contract. An arrangement is a service contract if the customer does not have the right to take possession of the software without a significant penalty or if it is not feasible to run the software on its own hardware. For these hosting arrangements, vendor fees are expensed over the term of the service agreement.
ASU 2018-15 aligns the accounting for implementation costs of a service contract with the guidance in ASC 350-40. This means that even though the software is not a customer asset, certain implementation costs can be capitalized. These costs are evaluated using the same three-stage model of expensing preliminary costs, capitalizing development costs, and expensing post-implementation costs.
The capitalized implementation costs are recorded as an asset on the balance sheet. These costs can include external direct costs of implementation and payroll costs for employees involved in the setup and configuration of the software. This asset is then amortized on a straight-line basis over the term of the hosting arrangement, including any renewal periods that are reasonably certain to be exercised.
Post-Capitalization Accounting
After software costs are capitalized as either an internal-use software asset or as implementation costs for a cloud arrangement, they are subject to ongoing accounting treatments. The two main processes involved are amortization and impairment testing.
Capitalized internal-use software costs must be amortized over the software’s estimated useful life. Amortization is the systematic expensing of an intangible asset’s cost over the period it is expected to provide benefits. The straight-line method is the most common approach, but other methods can be used if they are more representative of how the asset’s benefits are consumed. The amortization period begins when the software is ready for its intended use.
The capitalized asset must also be periodically evaluated for impairment. An impairment test is required when events suggest the carrying amount of the asset may not be recoverable. Such events could include a decrease in the software’s use, a change in business strategy, or technological obsolescence. If the carrying amount exceeds the undiscounted cash flows expected from the asset, an impairment loss is recognized for the difference between the carrying amount and the asset’s fair value.