On October 29, 2024, FASB issued an exposure draft to modernize the accounting for software costs. The proposal would make the following targeted changes to Accounting Standards Codification (ASC) 350-40, Internal-Use Software:
- Removes all references to a prescriptive and sequential software development method
- Adds criteria that must be met before the capitalization of software costs can start
- Requires cash paid for capitalized internal-use software costs to be included as a separate investing cash outflow in the statement of cash flows
- Incorporates website development guidance currently in ASC 350-50 into 350-40
The proposal does not change the determination of whether software is accounted for under ASC 350-40 or ASC 985-20, Software—Costs of Software to be Sold, Leased, or Marketed. Comments are requested by January 27, 2025.
Project Background
Over a three-year period, FASB has researched substantial overhauls to the accounting for capitalized software under both a single model and a dual model before settling on targeted improvements to the existing guidance for the accounting for internal-use software. The proposal is intended to address the changes in software development since the guidance was first issued 35 years ago. The growing use of agile software development upends the standardized phased workflows built into current accounting guidance, which has led to diversity in practice in determining when to begin to capitalize internal-use software costs.
Current Accounting Guidance
| Software Cost – Current Guidance Scope | |
|---|---|
| ASC 350-40, Internal-Use Software | ASC 985-20, Software—Costs of Software to be Sold, Leased, or Marketed |
| Cost incurred to develop or purchase software that is solely for the entity’s internal use | Cost incurred to develop software to be sold or licensed to customers |
| Cost to develop a hosting arrangement platform | Cost incurred to develop software used in a hosting arrangement in which the customer can take possession |
| Costs incurred by a customer to implement a cloud computing arrangement (CCA) | |
Proposed Changes ASC 350-40
The proposed amendments would remove all references to project stages in ASC 350-40, clarify the timing of the commencement of the capitalization of costs, and more closely align the recognition requirements for internal-use and external-use software costs.
Scope
The changes would apply to all entities subject to the guidance in ASC 350-40, as well as all entities that account for website development costs in accordance with ASC 340-50, Intangibles—Goodwill and Other—Website Development Costs.
Capitalization Threshold
Under the proposal, an entity would be required to start capitalizing software costs when both of the following occur:
- Management has authorized and committed to funding the software project.
- It is probable1 that the project will be completed, and the software will be used to perform the function intended.
Probable-to-Complete Threshold
In evaluating the probable-to-complete recognition threshold, an entity should consider if there is significant uncertainty associated with the software development activities. The exposure draft includes the following factors to consider in determining if there is significant uncertainty associated with the development activities:
- The software being developed has novel, unique, unproven functions and features or technological innovations. This is similar to the language in ASC 985-20.
- The significant performance requirements2 of the computer software have not been identified or continue to be substantially revised by the entity. Not all of a project’s performance requirements have to be identified and resolved before commencement of capitalization, only those identified as significant by management.
Statement of Cash Flows
Cash flows from capitalized software costs, other than implementation costs of a hosting arrangement that is a service contract, should be classified as cash outflows from investing activities and separately presented from other investing cash flows in the statement of cash flows.
Effective Date & Transition
An effective date and ability to early adopt will be determined after a review of comment letters. Companies would be allowed to adopt on a prospective or retrospective basis. For prospective application, an entity would apply the amendments to new and in-process projects incurred on or after the effective date. For a retrospective application, an entity would determine the cumulative effect of applying the amendment to all software costs as though they had been applied in previous periods and would recast prior period financial statements. Under the proposal, a cumulative effect adjustment would be made to the opening balance of retained earnings as of the beginning of the earliest period presented.
Conclusion
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