Statement of Position 98-1 for Internal-Use Software

When a company develops software for its own operations, such as a custom payroll system, the accounting for the associated costs is not a simple matter of expensing everything as it is paid. The American Institute of Certified Public Accountants (AICPA) originally issued guidance for these expenditures, which has since been incorporated into the Financial Accounting Standards Board’s (FASB) Accounting Standards Codification (ASC) as Subtopic 350-40, Internal-Use Software. In 2025, the FASB approved an update to this standard, modernizing the framework to align with current software development practices. Understanding this standard is important for accurately reflecting the value of these internally developed assets on a company’s financial statements.

The New Framework for Capitalizing Costs

An update to ASC 350-40 approved in 2025 eliminates the previous three-stage accounting model. Under the new guidance, the capitalization of costs for internal-use software begins once two criteria are met: management commits to funding the project, and it is “probable” that the project will be completed and the software will be used for its intended function. This change was made to better reflect modern development methodologies, such as Agile, where development is more fluid than a rigid, multi-stage process. The new standard is effective for fiscal years beginning after December 15, 2027, though early adoption is permitted.

Identifying Capitalizable vs. Expensable Costs

Once a project meets capitalization criteria, rules govern which costs are treated as assets versus expenses, and only costs directly attributable to developing functionality qualify. Capitalizable costs include external direct costs like fees paid to third-party developers. They also include payroll and related costs for employees directly involved in the project, like software engineers. Interest costs incurred during development can also be capitalized per ASC 835-20.

Certain costs must be expensed as incurred, including:

• General and administrative costs and overhead
• Data conversion costs, unless specific software is required for the conversion
• Training costs for employees

Accounting for Software After Development

Once the internal-use software is placed into service, the accounting focus shifts from capitalization to managing the asset over its operational life. The capitalized costs are recorded as an intangible asset on the balance sheet, and their value must be systematically allocated to expense over time. The mechanism for this allocation is amortization. The standard requires that capitalized software costs be amortized, typically using the straight-line method, over the software’s estimated useful life. Determining the useful life requires judgment and involves considering factors like expected technological obsolescence, the company’s future plans for the software, and any competitive or economic factors that could shorten its life. Amortization begins as soon as the software is ready for its intended use, after all substantial testing is complete.

In addition to amortization, companies must periodically evaluate the capitalized software for impairment. Impairment occurs when the carrying amount of the asset on the balance sheet is no longer recoverable and exceeds its fair value. Events that might trigger an impairment review include a significant change in how the software is used, the software becoming obsolete, or a plan to abandon or replace the software before the end of its estimated life. If an impairment is identified, the company must write down the asset’s value to its fair value and recognize the difference as a loss on the income statement.

Handling Upgrades and Cloud Computing Arrangements

The principles of ASC 350-40 also extend to common situations beyond the initial development of software, such as making improvements to existing systems and implementing cloud-based services. The core distinction often depends on whether the expenditure adds new capabilities or simply maintains existing ones. When a company modifies its existing internal-use software, the accounting treatment depends on the nature of the upgrade. If the modification adds new functionality that the software did not previously have, the associated costs should be capitalized. Costs incurred for routine maintenance, bug fixes, or minor tweaks that do not add functionality are considered operational expenses and are expensed as they are incurred.

The guidance has been adapted to address the rise of cloud computing and Software-as-a-Service (SaaS) arrangements. Under ASU 2018-15, a customer in a cloud hosting arrangement that is a service contract must capitalize certain implementation costs. These capitalizable costs are those incurred for activities like software configuration, customization, and testing. Once capitalized, these implementation costs are recorded as an asset and amortized, typically on a straight-line basis, over the term of the hosting arrangement, including any reasonably certain renewal periods.