Software Development Costs

All of us interact daily with software and are accustomed to dealing with regular updates.  Now, the GAAP accounting rules for certain types of software are being updated as well.  Accounting Standards Update (ASU) 2025-06, “Intangibles - Goodwill and Other - Internal Use Software (Subtopic 350-40),” was issued recently to modernize accounting for internal-use software and make targeted improvements to existing guidance.

Internal-use software is defined in accounting standards as, “software acquired, developed, or modified solely to meet an entity’s internal needs, with no substantive plan to market it externally.”

The following types of companies are likely to be most affected:

• Software-as-a-Service (SaaS) providers unlike on-premises licensing models accounted for under separate rules (software to be sold, leased or marketed), SaaS and cloud-delivery arrangements generally provide access to a hosted service, requiring related costs to be accounted for as internal-use software.
• Companies with in-house developers projects to enhance internal systems and processes often trigger capitalization requirements.
• Companies implementing new ERP systems both internal and third-party implementation costs must be evaluated for capitalization.

Under existing standards, capitalization determinations are based on prescriptive stages of project development (i.e., preliminary, application development and post-implementation/operation).  These stages have identifiable starts and stops and the guidance assumes progression and transition from stage to stage.  Costs incurred in certain stages are expensed, while others must be capitalized.

The new ASU acknowledges that the software development process has and will continue to evolve.  It’s now more incremental and iterative, blurring the lines between stages of development.  This evolution presents challenges in applying existing guidance to new processes.  The new ASU removes references to development stages and instead requires capitalization to begin once both of the following conditions are met:

• Management has authorized and committed to funding the project, and
• It’s probable the software will be completed and used as intended, including consideration of any significant development uncertainty

In practice, adoption of the new ASU may not significantly change the total amount of capitalized costs for many companies. However, it is expected to better align accounting with modern development practices and simplify the determination of which costs should be capitalized.

To prepare for adoption, companies should develop and document policies addressing:

• What constitutes a qualifying software project 
• How management authorization and funding commitment are identified 
• How probability of completion and intended use are assessed, including development uncertainty 
• When capitalization begins and ends 

The new guidance is effective for calendar year 2028, with early adoption permitted.  Several transition approaches are available to best meet the company’s needs.  While 2028 may seem distant, given the often lengthy software development life cycle, companies should evaluate and plan for the potential impact of these changes sooner rather than later.