Accounting treatment of software development costs

Mar 18, 2020
Financial reporting
Audit Intangibles & other assets Other accounting topics Technology industry

Many entities develop software that will either be used internally or sold to others. The primary subtopics in the Financial Accounting Standards Board's Accounting Standards Codification (ASC) that must be considered when determining the accounting treatment for the related software development costs are ASC 985-20, Software – Costs of Software to be Sold, Leased, or Marketed, and ASC 350-40, Intangibles – Goodwill and Other – Internal-Use Software. ASC 985-20 is applicable to costs incurred to develop or purchase software to be sold, leased or otherwise marketed as a separate product or as part of a product or process, while ASC 350-40 is applicable to costs incurred to develop or obtain software solely to meet an entity's internal needs and for which no substantive plan exists or is being developed to externally market the software. The application of the guidance in ASC 985-20 versus ASC 350-40 can result in significantly different accounting treatments for these costs. As a result, it is important for entities to ensure they are following the appropriate guidance.

In many cases, it is quite clear which of these ASC subtopics should be followed. However, the question often arises with respect to whether ASC 985-20 or ASC 350-40 should be applied to the software development costs incurred by entities that develop software and provide access to or host the software through the internet (i.e., software as a service (SAAS)) rather than transferring possession of the software to the customer. The answer to this question hinges on whether the SAAS arrangement meets the following criteria: (a) the customer can contractually take possession of the software during the hosting period without a significant penalty and (b) the customer can feasibly either run the software itself or contract with another party unrelated to the entity to host the software. If these criteria are met, the related software development costs are within the scope of ASC 985-20. In practice, however, these criteria are not met very often in SAAS arrangements. As a result, the related software development costs would typically be within the scope of ASC 350-40 because the software is considered to be for the entity's internal use to provide a service to the customer.

Note that in many situations, an entity may not have entered into any revenue arrangements for software under development. In other words, the entity is incurring software development costs before it enters into any revenue arrangements that include the software. To properly account for the software development costs in these situations, an entity must determine whether it expects future revenue arrangements related to the software under development to meet the criteria in the preceding paragraph. Furthermore, if an entity concludes that any of its future revenue arrangements relating to the software under development will meet this criteria, all related software development costs would be within the scope of ASC 985-20. This is because ASC 350-40 only applies if the software is (or will be) used solely for internal purposes.

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