Proper Accounting Treatment for Software Capitalization
Technology companies have historically struggled with the lack of assets on their balance sheet. In some cases, these companies may be misapplying software capitalization guidance under Accounting Standards Codification (ASC) 985-20 and ASC 350-40. In today’s world, almost every company can call itself a technology company, so it is more important than ever to understand the proper accounting treatment for potential software capitalization. In this article, we will examine the proper accounting guidance to follow along with some common mistakes we see when assisting clients with software capitalization.
Determining the Proper Guidance
The first step is to determine the proper accounting guidance to follow—ASC 350-40, Intangibles—Goodwill and Other—Internal-Use Software, or ASC 985-20, Software—Costs of Software to Be Sold, Leased, or Marketed. In general, if the software is to be sold, the entity will follow ASC 985-20, and if there is no intention to sell, the entity will follow ASC 350-40. In more detail:
- ASC 985-20: Applies to software development costs for a software product that will either be sold or embedded in a product that will subsequently be sold, leased, or otherwise marketed.
- ASC 350-40: Applies when there is no intention to sell the software; rather, it will be used solely in operating an entity’s business, including:
- For a vendor – When the software will be used by the vendor in providing a cloud computing service arrangement where the customer does not take possession of the software and cannot host it on its own.
- For a customer – When the customer can take possession of the software and host it on its own.
Software within the scope of ASC 985-20 is commonly sold as a perpetual or term license. In determining whether software development costs should be capitalized, the entity should access if there is a plan to market the software externally. Costs can only be capitalized once technological feasibility has been established. Technological feasibility is achieved when an entity has completed all planning, designing, coding, and testing activities necessary to establish that the software product can be produced to meet its design specifications, including functions, features, and technical performance requirements. Per ASC 985-20-25-1, this can be achieved using either:
- A detail program design, or
- The combination of a product design and working model, which have been confirmed for completeness by testing
The costs incurred to establish feasibility are to be expensed as incurred as required by ASC 730.
A software product is defined by ASC 985-20-55-1 as having the following qualities:
- As a product, it is complete and has exchange value.
- As software, it is a set of programs that interact with each other. A program is further defined as a series of instructions or statements that cause a computer to do work.
Software products can be purchased or developed by an entity’s employees. ASC 985-20 does not have an ownership requirement, so an entity may obtain the marketing rights for an acquired product and capitalize these costs as a software product.
Software Subject to a Hosting Arrangement
Certain software subject to a hosting arrangement, such as software as a service (SaaS) that is sold, is within the scope of ASC 985-20 if both of the following criteria are met from ASC 985-20-15-5:
- The customer has the contractual right to take possession of the software at any time during the hosting period without significant penalty.
- It is feasible for the customer to either run the software on its own hardware or contract with another party unrelated to the vendor to host the software.
If these criteria are met, only the software costs are capitalizable under ASC 985-20. Costs of other assets associated with the hosting would fall under other guidance. If the criteria are not met, the entity should account for the software costs under ASC 350-40.
ASC 350-40-15-2A describes internal-use software as having both of the following characteristics:
- The software is acquired, internally developed, or modified solely to meet the entity’s internal needs.
- During the software’s development or modification, no substantive plan exists or is being developed to market the software externally.
Not all software costs are capitalized when developing internal-use software. Depending on the development phase, certain costs may be expensed. ASC 350-40-55-3 illustrates the various stages and related processes of computer software development:
- Preliminary project stage
- Conceptual formulation of alternatives
- Evaluation of alternatives
- Determination of existence of needed technology
- Final selection of alternatives
- Application development stage
- Design of chosen path, including software configuration and software interfaces
- Installation to hardware
- Testing, including parallel processing phase
- Post-implementation – operation stage
- Application maintenance
The costs associated with the preliminary project phase and post-implementation phase are expensed. The costs associated with the application and development stage are capitalized. An entity should consider all activities being performed when determining the stage of development. Internal tracking of each of these phases is important to determine when to capitalize or expense costs.
If you have any other questions related to software capitalization and its requirements, please reach out to a professional at FORVIS or submit the Contact Us form below.