FASB modernizes accounting for internal-use software costs

Introduction and background

The Financial Accounting Standards Board (FASB) has issued Accounting Standards Update (ASU) No. 2025-06, Intangibles-Goodwill and Other-Internal-Use Software (Subtopic 350-40): Targeted Improvements to the Accounting for Internal-Use Software, finalizing Proposed ASU No. 2024-ED400 of the same name, with the purpose of better aligning recognition guidance with current software development methods. Under existing United States generally accepted accounting principles (U.S. GAAP), entities are required to capitalize costs incurred for internal-use software depending on both the nature of the costs incurred and the project stage in which they occur (i.e., preliminary project stage, application development stage, or postimplementation operation stage). With the shift from using a prescriptive and sequential development method to using an iterative and incremental software development method (e.g., agile), entities face challenges when attempting to differentiate between various project stages and, consequently, when determining to begin capitalizing internal-use software costs.

The amended rules remove the requirements in FASB Accounting Standards Codification (ASC), Subtopic 350-40, Intangibles-Goodwill and Other-Internal-Use Software, for entities to differentiate between software development project stages. Specifically, the update removes all references to prescriptive and sequential software development stages, instead requiring entities to capitalize software costs once the funding for the project has been both committed to and authorized by management and once it meets a specific recognition threshold. These changes make the guidance more reflective of modern business practices.

Amended guidance

Following is a discussion of the main points of the amended guidance:

• Entities must begin capitalizing software costs when both of the following occur: (1) the funding of the software project has been committed to and authorized by management (e.g., the execution of contracts with third parties and the approval of expenditures related to internal or external software development) and (2) the software project meets the "probable-to-complete" recognition threshold (i.e., the project's completion is probable and the software will be used to perform the function intended)
• To meet the "probable-to-complete" threshold, entities must determine whether there is significant uncertainty associated with the software's development, which exists if either of the following factors is present:
  
  The significant performance requirements of the software have not been identified, or are continually substantially revised, by the entity
• If the above capitalization requirements are no longer met for the software being developed, the asset must be reported at the lower of the carrying amount or fair value, if any, less the cost to sell the asset
• Entities must provide the disclosures in FASB ASC 360-10, Property, Plant, and Equipment-Overall, for all capitalized internal-use software costs, regardless of how they present those costs in the financial statements
• The intangibles disclosures in FASB ASC 350-30, Intangibles-Goodwill and Other-General Intangibles Other Than Goodwill, are not required for capitalized internal-use software costs
• Note that Proposed ASU No. 2024-ED400 contemplated additional presentation and disclosure requirements for internal-use software costs; however, the FASB decided to omit these from the final standard based on stakeholder feedback.

Effective date and transition

The amendments in this ASU are effective for all entities for annual reporting periods beginning after Dec. 15, 2027, and for interim reporting periods within those annual periods. Early adoption is permitted in an interim or annual reporting period during which the financial statements have not yet been issued or made available for issuance. Entities adopting the rules in an interim reporting period must adopt the rules as of the beginning of the annual reporting period that includes that interim reporting period.

Entities may apply the guidance in one of the following ways, with the appropriate transition disclosures provided in both the interim reporting period (if applicable) and the annual reporting period of the change:

• Prospectively to new software costs incurred as of the beginning of the period of adoption for all projects (including in-process projects);
• Retrospectively, by recognizing a cumulative-effect adjustment to the opening balance of retained earnings (or other appropriate components of equity or net assets) as of the beginning of the first period presented; or
• Using a modified transition approach based on project status and the timing of capitalization of software costs. When opting for this approach, entities should apply the amendments in this ASU as follows:
  
  Prospectively to new software costs incurred for all projects (including in-process projects), except for any in-process projects that, as of the date of adoption, do not meet the amended capitalization requirements, but still meet the capitalization requirements under current guidance
  
  For specific in-process projects, derecognition of capitalized costs through a cumulative-effect adjustment to the opening balance of retained earnings (or other appropriate components of equity or net assets) as of the date of adoption

Once ASU No. 2025-06 is effective, all of FASB ASC 350-50, Intangibles-Goodwill and Other-Website Development Costs, are superseded and the guidance for website-specific development costs is incorporated into FASB ASC 350-40. The ASU makes conforming amendments to other areas of U.S. GAAP.

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