Businesses continually look for ways to improve their processes and streamline operations, giving them a competitive edge in their industry. Technology plays an important role, with organizations looking to either buy or develop software that can help them achieve critical efficiencies.
But how do you account for these costs, which are often substantial? Under Generally Accepted Accounting Principles (GAAP), particularly Accounting Standards Codification 350-40, businesses must capitalize certain internal-use software costs on the balance sheet as intangible assets and amortize them over the useful life of the software. Capitalizing internal-use software costs is not only required, but doing so can improve your company’s statement of operations by spreading out your tech costs across multiple years.
So, what is considered internal-use software? What types of costs can be capitalized, and how do you track them? What is the appropriate useful life to amortize? What about hosting arrangements? We dive into these and other key questions to help guide you through the process of capitalizing these important costs.
Internal-use software under ASC 350-40 must meet two characteristics:
A substantive plan to market the software externally could include the selection of a marketing channel(s) and the identification of promotional, delivery, billing and support activities. To be considered a substantive plan, the implementation of the plan should be reasonably possible.
The FASB provides guidance on which activities should be capitalized and which should be expensed. An internal-use software development project is categorized into four phases:
The table below summarizes general activities by phase and whether to capitalize or expense each.
| Preliminary Project Phase | Application Development Phase | Post-Implementation or Operation Phase | Upgrades and Enhancements Phase | |
|---|---|---|---|---|
| General Activities | Conceptually formulating alternatives Evaluating alternatives Determining if needed technology already exists Selecting final alternatives |
Designing chosen path, including software configuration and interfaces Coding Installing hardware Testing, including parallel processing phase Training costs |
Internal or external training Application maintenance |
Modifying existing software, resulting in additional functionality Maintaining software, including bug fixes |
| Capitalize or Expense? | Expense as incurred | Capitalize Exception: Training costs at this phase are expensed as incurred |
Expense as incurred | Capitalize any modifications resulting in additional functionality Expense maintenance and bug fixes as incurred |
Expanding on the chart above, capitalization of costs should begin when both of the following occur:
Capitalization of costs should end when either of the following occurs:
When the developed software needs upgraded or enhanced, modifications that result in additional functionality are capitalized, while bug fixes and routine maintenance are expensed.
Now that we have identified the activities and breakdown between capitalization and expense, we can dive deeper into which costs of obtaining or developing internal-use software can be capitalized, including the following:
| External, Direct Cost of Materials and Services | Payroll and Related Expenses | Interest Costs in Developing Internal-Use Software |
|---|---|---|
| Fees paid to third parties to develop the software Costs incurred to obtain software from third parties Travel expenses incurred by employees for work directly related with the software development |
Employees directly associated with/ devote time to the software project
|
Interest incurred in accordance with ASC 835-20 – Capitalization of Interest Note: If your company suspends all activities related to developing/obtaining the internal-use software, stop interest capitalization until you resume project activities |
General and administrative costs, including overhead costs, are not capitalized.
Software can easily become outdated or obsolete with the rapid pace of technology. Internal-use software is no different, generally known for its short “useful life” — the span of time for which it’s expected to be in service and effective.
As such, it is typical to amortize internal-use software on a straight-line basis over a three- to five-year life; however, a longer life may be used for justifiable reasons. It’s a best practice to periodically reassess the estimated useful life of the software, evaluating factors such as:
Amortization over the estimated useful life begins when the software is ready for use, regardless of when the software is placed in service.
Impairment occurs when the actual value of the software is below the book value. Impairment is triggered, often by events and circumstance, when the book value of the software may not be recoverable.
Once you’ve begun activity related to developing new software, it’s time to consider the remaining useful lives of the software you will be replacing. When an entity replaces existing software with new software, unamortized costs of the old software should be expensed when the new software is ready for intended use. Impairment should be recognized and measured.
If you are licensing a software product — in which you as the end-user do not take possession of the software but simply access and use it — internal-use software accounting applies IF both of these criteria are met:
Often, licensed software is hosted on a vendor’s servers or on a third-party cloud platform, rather than installed into local servers. The rules for capitalizing this type of software is consistent with the guidance described above for internal-use software.
Technology is complex and necessary, both for your company’s success and as is it relates to accounting. It is important to properly track all costs related to capitalized internal-use software costs. To substantiate capitalization with your auditors, be sure to maintain payroll reports and related payroll benefit documentation, timesheets for employees who have directly worked on the project, invoices from outside vendors or service providers, and reports/workbooks to calculate and allocate the capitalized costs.
Contact Logan Rose or a member of your service team to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.