The Difference Between Capitalizing Internal- and External-Use Software

The costs of developing software for an organization’s internal use are accounted for differently than software designed to be sold, leased, or marketed. This includes software developed to provide a service to a customer, including SaaS. Here are some of the differences between capitalizing internal-use and external-use software costs. 

Internal-Use Software Capitalization 

Capitalizable costs for internal-use software include development, labor, and third-party software development or purchase costs. Non-capitalizable costs include overhead, administrative, training, and maintenance. Internal-use software should be amortized over its useful life, which typically ranges from two to five years. Amortization should begin when the internal-use software is ready for its intended use rather than when it is to be placed in service. 

Several factors may make internal-use software costs non-recoverable, including:  

1. The software isn’t expected to perform as intended;  
2. The software’s use is expected to change considerably;  
3. A significant change is made to the software;  
4. The costs to develop or modify the software vastly exceed the anticipated amount; and  
5. The software is no longer being used. 

In these situations, the organization may need to write down (or completely write off) the cost of the software and any accumulated amortization recorded up to that point and record the difference as an impairment loss on the income statement. 

For future work performed on internal-use software already implemented, the costs of minor upgrades or fixing bugs and other maintenance-type work on existing software are not capitalizable. However, more substantial work can be capitalized.  

When considering work on pre-existing internal-use software, ask: “Am I adding significant functionality?” For example, an organization shouldn’t capitalize work on monthly system updates and bug fixes, but it could capitalize the development costs when it adds functionality such as video capability. 

External-Use Software Capitalization Under ASC 985-20 

External-use software developed to sell, lease, or market falls under different rules: ASC 985-20. Firms must achieve “technological feasibility” before they can capitalize certain costs.  

ASC 985-20 states that technological feasibility is established when “the entity has completed all planning, designing, coding, and testing activities that are necessary to establish that the product can be produced to meet its design specifications, including functions, features, and technical performance requirements.” For example, completing a detailed program design or a working alpha version can often establish technological feasibility. 

Costs prior to achieving technological feasibility are expensed as incurred. Once technological feasibility is achieved, firms can capitalize certain costs, including overhead in some cases. Organizations can no longer capitalize the software costs once the product is in the marketplace, and like internal-use software, maintenance and customer support costs are expensed as incurred. 

Amortization of External-Use Software 

Amortization of external-use software should begin when the product is available for distribution to customers and should be recorded to cost of sales. Like internal-use software, firms must periodically evaluate the capitalized development costs for impairment. An organization with internal-use software will generally begin capitalizing costs sooner than one with external-use software, as technological feasibility tends to be achieved later in development. 

The FASB has a current project on the accounting and disclosure of software costs, including ASC 350-40 and ASC 985-20, and expects to release an exposure draft later this year.