Accounting for Software Development Costs: What Technology Companies Need to Know

Written by: Kiriaki Giannoulas, CPA

As technology companies gear up to prepare their budgets for the upcoming year, it is important to consider the accounting treatment of software development costs.  The decision to expense or capitalize these costs, guided by the authoritative standards set forth by the Financial Accounting Standards Board (FASB), can have a significant impact on profitability and influence the long-term financial and strategic impact of software initiatives. There are two accounting standards relevant to software development costs: ASC 985-20 related to software developed to be sold or leased to others, and ASC 350-40 for internal use software. Understanding the nuances between the two standards is critical to ensure these costs are properly treated.

Current Accounting Guidance

Under ASC 985-20, companies such as those developing licensed software for installation on users’ computers or servers capitalize costs incurred to internally develop, produce, or purchase software intended for sale, lease, or external marketing, once technological feasibility is established. Technological feasibility is achieved when all necessary planning, designing, coding, and testing are completed to ensure the product meets its design specifications. Costs incurred prior to reaching technological feasibility are treated as research and development costs and accordingly expensed. Once technological feasibility is established, these costs are capitalized until the software is ready for general release. Once the software is available for sale, the capitalized costs are amortized over its estimated economic life. Costs related to subsequent product enhancements may also be capitalized under ASC 985-20 if they meet certain requirements.

In contrast, ASC 350-40 focuses on accounting for internally used software, commonly used by cloud-hosted SaaS companies that maintain and host software for customers to access. Development is broken down into 3 stages: (i) the preliminary project stage, (ii)the application development stage, and (iii) the post-implementation stage. Only costs in the application development stage, such as application design and testing, are eligible to be capitalized, while costs in the preliminary and post-implementation stages are typically expensed. Traditionally, software development followed a linear or “waterfall” method, progressing sequentially through the stages outlined in ASC 350-40. Most software today is developed using agile methodologies, where development teams engage in sprints for planning and execution, effectively dividing larger projects into smaller and more manageable increments. This approach fosters continuous feedback and iterative improvements, resulting in features and functionalities that are individually developed and constantly evolving. As a result, applying ASC 350-40 to the nonlinear nature of agile development is challenging, as it often does not align with the specific project stages prescribed in the standard.

Proposed Accounting Updates

In response to the framework challenges of ASC 350-40, the FASB tentatively agreed upon significant updates to modernize it, on June 18, 2024. The proposed changes remove the traditional three-stage model, allowing capitalization to begin once management authorizes and commits to project funding and determines the project is probable to complete. This updated approach requires a more stringent assessment of the probable to complete recognition threshold, with entities evaluating any significant development uncertainties—such as unresolved high-risk development issues—before capitalization begins. The update further defines the term “probable” as the future event is likely to occur.

While these changes are intended to provide clearer guidance for capitalizing costs, particularly those related to cloud-based solutions, and to better reflect modern technology trends, they make it more difficult for technology companies to meet the criteria to capitalize their development costs. Notably, the FASB decided not to propose any updates to ASC 985-20 during their meeting. For technology companies heavily invested in internal software, these updates have the potential to reshape how software investments are presented on financial statements, impacting asset recognition, expense timing, and overall financial reporting.

These proposed changes highlight the importance of informed judgment in recognizing software costs, ensuring consistency and transparency in financial reporting. Adapting to these new guidelines will better equip companies to maintain financial accuracy and transparency, ultimately supporting more strategic decision-making in software development initiatives. Whether developing software for the market or internal use, staying aligned with these evolving standards is essential for effective financial management in today’s environment.

We are closely monitoring the situation and will provide an update once a decision has been made regarding the implementation of the proposed changes.

For more information on accounting for software development costs for your technology company, please contact Chris Noble, Matthew Rosenblatt, or your Anchin Relationship Partner.