SOP 98-2: Accounting for Internal-Use Software Costs
Clarifies the accounting framework for internal-use software, guiding the decision to capitalize or expense costs from development through to cloud arrangements.
Statement of Position (SOP) 98-1 was an accounting standard from the American Institute of Certified Public Accountants (AICPA) for software developed or obtained for internal use. Its objective was to standardize when these costs should be an immediate expense versus when they should be capitalized as a long-term asset. The principles from SOP 98-1 have since been incorporated into the Financial Accounting Standards Board’s (FASB) framework under Accounting Standards Codification (ASC) 350-40.
Core Accounting Treatment for Internal-Use Software
The accounting framework for internal-use software is structured around three distinct phases of a project’s lifecycle. This staged approach dictates whether an expenditure is expensed immediately or capitalized. The classification is based on the specific activities performed during each phase of development and implementation.
Preliminary Project Stage
The preliminary project stage involves conceptualizing the project and exploring its feasibility. Activities include evaluating technological alternatives, determining system requirements, and selecting vendors or development options. All costs from this exploratory phase are expensed as incurred because management has not yet formally committed to a specific course of action.
Application Development Stage
The application development stage includes the design, coding, and testing of the software and is the only phase where costs may be capitalized. Capitalization begins once the preliminary stage is complete and management authorizes and commits funding to the project. This period ends when the software is substantially complete and ready for its intended use after all significant testing is finished.
Post-Implementation and Operation Stage
After the software is placed into service, it enters the post-implementation and operation stage. Costs related to ongoing activities like user training, maintenance, and technical support are expensed as incurred. These expenditures do not add new functionality but instead ensure the software’s continued operation.
Categorizing Specific Project Costs
The accounting treatment of a specific cost depends on the project stage and the nature of the activity.
Capitalizable Costs
Costs eligible for capitalization are incurred during the application development stage and are directly related to creating the software. This includes payments to third parties for development, payroll costs for employees directly involved in the project, and interest costs incurred during the development period.
Expensable Costs
Costs that must be expensed are incurred during the preliminary or post-implementation stages. Examples of expensable costs include:
- Initial costs of strategic planning and vendor selection
- Data conversion, unless necessary for the software to be operational
- Training employees on how to use the new system
- Fees for ongoing maintenance and technical support
Post-Capitalization Accounting
After internal-use software costs are capitalized as an intangible asset, they are subject to specific accounting procedures throughout their operational life, including amortization and impairment testing.
Amortization
The capitalized cost of software is allocated as an expense over its estimated useful life through amortization, which begins once the software is placed into service. The straight-line method is most common, spreading the cost evenly over the asset’s life. The useful life is determined by considering factors such as obsolescence, technology, competition, and other economic factors.
Impairment
Capitalized software must be periodically evaluated for impairment, which occurs if the asset’s carrying value may not be recoverable. Indicators include the software becoming obsolete, being replaced, or a significant change in its use. If impairment is identified, the asset’s value is written down to its fair value, with the loss recognized on the income statement.
Current Guidance and Cloud Computing Arrangements
This accounting guidance has been adapted to address modern developments like cloud computing and Software as a Service (SaaS) models. An update clarified how to account for implementation costs in a cloud computing arrangement that is treated as a service contract.
A customer in a cloud arrangement should capitalize certain implementation costs incurred during the application development stage, such as configuring the software, testing its functionality, and converting data. Once capitalized, these costs are treated as an asset and amortized over the term of the hosting arrangement, including any reasonably certain renewal options.
The Financial Accounting Standards Board (FASB) is also reviewing this topic. A proposed Accounting Standards Update was issued in late 2024 that could introduce targeted improvements to the standard.