The capitalization of software development costs was a consideration for accountants as early as 1985. Over 35 years ago the FASB issued Statement No. 86 Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed to provide specific guidance where none previously existed. To be clear, accounting guidance for computer software in general was published, but nothing specifically addressed internally developed software for sale.
The accounting profession has progressed rapidly since the 1980s, as has business and commerce. Several additional rules have either been published or amended relating to software as our use of software has become more prevalent and the types of software arrangements offered has expanded. Most recently ASC 350 Intangibles – Goodwill and Others was originally published in early 2015 to be effective beginning in 2016.
However, stakeholders requested further clarification during the comment period and after applying the updated rules throughout 2016. The FASB published an amendment to ASC 350-40 in 2018 specifically for internal use software. The updates to ASC 350-40 are effective for public entities for fiscal years beginning after December 15, 2019, and interim periods of public entities within those fiscal years. Therefore, a public entity with a calendar year end adopted the amended ASC 350-40 as of January 1, 2020. For non-public entities, the amended ASC 350-40 is effective for annual reporting periods beginning after December 15, 2020.
The history of software capitalization for state and local governments is similar to that of FASB. Issued June 2007, GASB 51, Accounting and Financial Reporting for Intangible Assets provides a summary for rules regarding software capitalization to provide consistency for how organizations should account for the intangible assets. However, the evolution of technology and increased use of software required additional standards and clarification. In 2020, therefore, GASB issued statement No. 96, Subscription-based IT Arrangements effective for fiscal years beginning after June 15, 2022 to address contracts for software services.
As alluded to above, the accounting treatment for software has evolved as software offerings have increased and advanced as well. When reviewing accounting treatment of software, three main types should be considered:
- Purchased software
- Internally developed software
- Software as a service (SaaS)
Software first appeared to the consumer or medium- and small-sized businesses as an intangible asset to purchase. It was developed and sold by very few companies, such as HP and IBM, who had experience with computer technology and were the first pioneers of the technological revolution.
In the very early days, computer software was purchased on a floppy disk or diskette. The disk itself had no significant value, but the information or coded instructions on the disk could be an intangible asset. While software is rarely ever sold as a disk anymore, occasionally a company will need to purchase “out-of-the-box” or “off-the-shelf” software. This terminology is applied when no customizations or enhancements are needed for the software to be used by the purchaser.
When software is purchased by an entity and used directly out of the box, under US GAAP it is recorded on the balance sheet as an intangible asset at purchase price and amortized over its economic or legal life, whichever is shorter. The economic life is the period over which the intangible asset contributes to the cash flows of an organization. The legal life is the contractual term of the intangible asset. If the asset has an indefinite useful life, it is not amortized, but must be analyzed periodically for impairment of value.
GASB 51 explicitly names computer software as an intangible asset owned by state and local governments. Under this guidance, software is treated as a capital asset recorded on the statement of financial position at its purchase price and amortized by a rational and systematic method over its useful life, or if its usefulness is determined to be indefinite, it would not be amortized.
As organizations became more familiar with technology and increasingly relied on it, more customization appeared. In order to gain an advantage over competitors, an entity now wanted software developed for their particular needs. Either an organization purchased software off the shelf to enhance themselves and contracted with the vendor to customize, or the organization developed the software internally. In both cases additional guidance was published to provide for the capitalization of some of the development costs. Furthermore, as more companies entered the technology industry, standards were also drafted to establish guidance for internally developed software to be sold.
Under US GAAP the software capitalization rules for a purchased or developed software intended to be used internally are differentiated from the rules for software for sale. In general, the implementation costs, or costs after planning and design, for internal-use software are capitalizable while the ongoing maintenance costs are not. To explain further, costs related to:
- purchases of software or software licenses,
- software development,
- coding and testing, or
- purchases of external materials
are the types of expenses to capitalize. Any costs related to ongoing operations of the software or software licenses such as training, manual data conversion, and maintenance and support costs are not capitalizable.
When software is developed for sale, or external use, the accounting treatment differs slightly. The capitalizable and non-capitalizable costs are still delineated by where or when in the process they occur, but the guidance becomes more granular. Costs to develop external-use software are not capitalizable until the software is declared technologically feasible. Technological feasibility is determined after planning, designing, coding, and testing. If these preliminary steps lead to a realistic product, the remaining development work for features and functionality – from both internal resources and third-parties – can be capitalizable.
The GASB’s accounting treatment for software is separated by different criteria than US GAAP. Software to be used internally is determined to be an intangible asset and considered to be in scope under GASB 51. However, the rules for capitalization of software costs under GASB are similar to those under FASB. GASB 51 allows for costs related to the application development stage of software creation to be capitalized. The application development stage is looked at as the stage after the product has been determined to be technologically feasible but before maintenance and ongoing operation.
Also similar to FASB, the definition of this stage is less broad than the capitalizable costs for internally developed software under US GAAP. Installation, testing, and parallel processing are deemed to be application development activities, but training is defined as a post-implementation activity.
External-use software, or software developed for market, is excluded from the scope of GASB 51 and should follow the guidance for investments, GASB 72 Fair Value Measurement and Application, as an asset held by the government primarily for the purpose of profit. Investments under GASB 72 are generally measured at fair value.
The more recent changes to software and its use have been related to a movement towards cloud computing arrangements and software subscriptions. With these types of arrangements, an organization is not purchasing a specific software, but instead a license or subscription to use the software over a specific period of time. Additionally, as technology has evolved the licenses or subscriptions have moved to being available over the internet or in the cloud.
The answer to this evolution for FASB is the issuance of FASB Subtopic ASC 350-40 Customer’s Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contact (ASC 350-40) in 2018. Under ASC 350-40 certain implementation costs for cloud computing or hosting arrangements can now be capitalized. Read our article ASC 350-40: Internal-Use Software Accounting & Capitalization for more details on this accounting update.
GASB also issued new guidance to address accounting for IT services. GASB 96 Subscription-based Information Technology Arrangements (GASB 96) was published in 2020 to become effective for organizations with fiscal years beginning after June 15, 2022, and all reporting periods thereafter. The standard was written to mirror GASB 87 in that once an organization determines they have a SBITA within the scope of GASB 96, they establish a subscription asset and subscription liability based on the total expected payments to be made over the subscription term.
We have published an article summarizing the accounting concepts of GASB 96 and an article with a comprehensive example of applying GASB 96 for further explanation of the accounting treatment proscribed in the statement.
Just like with leases, the accounting boards are updating the accounting treatment for software contracts to provide more transparency and consistency to financial reporting. Unlike lease accounting where one completely new standard was issued after forty years, several updates to accounting for technology have been made over the past decades as entities’ adoption of various software has evolved.
As the digital transformation takes us from the simple accounting for a purchased disk to software development costs to various service arrangements, the FASB and GASB have issued new guidance to keep up with the progress being made.