How to Capitalize Your Company’s Internal-Use Software Costs

Businesses continually look for ways to improve their processes and streamline operations, giving them a competitive edge in their industry. Technology plays an important role, with organizations looking to either buy or develop software that can help them achieve critical efficiencies.

But how do you account for these costs, which are often substantial? Under Generally Accepted Accounting Principles (GAAP), particularly Accounting Standards Codification 350-40, businesses must capitalize certain internal-use software costs on the balance sheet as intangible assets and amortize them over the useful life of the software. Capitalizing internal-use software costs is not only required, but doing so can improve your company's statement of operations by spreading out your tech costs across multiple years.

So, what is considered internal-use software? What types of costs can be capitalized, and how do you track them? What is the appropriate useful life to amortize? What about hosting arrangements? We dive into these and other key questions to help guide you through the process of capitalizing these important costs.

What is Internal-Use Software?

Internal-use software under ASC 350-40 must meet two characteristics:

1. It is acquired from a third party, internally developed or modified solely to meet your company's internal needs; and
2. During the software's development or modification, there is no substantive plan, existing or in progress, to market the software externally.

A substantive plan to market the software externally could include the selection of a marketing channel(s) and the identification of promotional, delivery, billing and support activities. To be considered a substantive plan, the implementation of the plan should be reasonably possible.

What Types of Internal-Use Software Activities Can Be Capitalized?

The FASB provides guidance on which activities should be capitalized and which should be expensed. An internal-use software development project is categorized into four phases:

1. Preliminary Project
2. Application Development
3. Post Implementation or Operation
4. Upgrades and Enhancements

The table below summarizes general activities by phase and whether to capitalize or expense each.

	Preliminary Project Phase	Application Development Phase	Post-Implementation or Operation Phase	Upgrades and Enhancements Phase
General Activities	Conceptually formulating alternatives Evaluating alternatives Determining if needed technology already exists Selecting final alternatives	Designing chosen path, including software configuration and interfaces Coding Installing hardware Testing, including parallel processing phase Training costs	Internal or external training Application maintenance	Modifying existing software, resulting in additional functionality Maintaining software, including bug fixes
Capitalize or Expense?	Expense as incurred	Capitalize Exception: Training costs at this phase are expensed as incurred	Expense as incurred	Capitalize any modifications resulting in additional functionality Expense maintenance and bug fixes as incurred

When Should the Capitalization Period for Internal-Use Software Begin and End?

Expanding on the chart above, capitalization of costs should begin when both of the following occur:

• The preliminary project stage is completed. This is typically when the application development phase begins.
• When management, along with the relevant authority, implicitly or explicitly authorizes and commits to funding a project; when it is probable the project will be completed; and when it is determined the software will be used to perform the function intended. Examples of authorization include when you execute a contract with a third party to develop the software, approve expenditures related to internal development, or commit to obtain the software from a third party.

Capitalization of costs should end when either of the following occurs:

• The company determines the product being developed will not be used or cannot be completed. At this time you should apply testing of impairment to costs already capitalized (see below for impairment considerations).
• The point at which the computer software is substantially complete and ready for its intended use, after substantial testing is completed. This is typically the beginning of the post-implementation stage, at which time costs are generally expensed.

When the developed software needs upgraded or enhanced, modifications that result in additional functionality are capitalized, while bug fixes and routine maintenance are expensed.

What Types of Internal-Use Software Costs Can Be Capitalized at the Application Development Stage?

Now that we have identified the activities and breakdown between capitalization and expense, we can dive deeper into which costs of obtaining or developing internal-use software can be capitalized, including the following:

External, Direct Cost of Materials and Services	Payroll and Related Expenses	Interest Costs in Developing Internal-Use Software
Fees paid to third parties to develop the software Costs incurred to obtain software from third parties Travel expenses incurred by employees for work directly related with the software development	Employees directly associated with/ devote time to the software project Only time spent directly on the project can be capitalized, such as software engineers coding and testing Includes cost of employee benefits	Interest incurred in accordance with ASC 835-20 - Capitalization of Interest Note: If your company suspends all activities related to developing/obtaining the internal-use software, stop interest capitalization until you resume project activities

General and administrative costs, including overhead costs, are not capitalized.

What is an Appropriate Useful Life of Internal-Use Software?

Software can easily become outdated or obsolete with the rapid pace of technology. Internal-use software is no different, generally known for its short "useful life" - the span of time for which it's expected to be in service and effective.

As such, it is typical to amortize internal-use software on a straight-line basis over a three- to five-year life; however, a longer life may be used for justifiable reasons. It's a best practice to periodically reassess the estimated useful life of the software, evaluating factors such as:

• The use of the technology (is it still effective, are there better options, is it obsolete, etc.);
• Competition (what are they doing/using and is it giving them an advantage);
• Broader economic factors (what is happening overall in the market); and
• Rapid changes in the development of software products, operating systems, or hardware and whether management intends to replace inferior hardware or software.

Amortization over the estimated useful life begins when the software is ready for use, regardless of when the software is placed in service.

Impairment of Internal-Use Software

Impairment occurs when the actual value of the software is below the book value. Impairment is triggered, often by events and circumstance, when the book value of the software may not be recoverable.

Once you've begun activity related to developing new software, it's time to consider the remaining useful lives of the software you will be replacing. When an entity replaces existing software with new software, unamortized costs of the old software should be expensed when the new software is ready for intended use. Impairment should be recognized and measured.

How Do You Account for Licensing/Hosting Internal-Use Software Arrangements?

If you are licensing a software product - in which you as the end-user do not take possession of the software but simply access and use it - internal-use software accounting applies IF both of these criteria are met:

1. You as the customer have the contractual right to take possession of the software at any time during the hosting period, without significant penalty; and
2. If it is feasible, you can either run the software on its own hardware or contract with another party unrelated to the vendor to host the software.

Often, licensed software is hosted on a vendor's servers or on a third-party cloud platform, rather than installed into local servers. The rules for capitalizing this type of software is consistent with the guidance described above for internal-use software.

Technology is complex and necessary, both for your company's success and as is it relates to accounting. It is important to properly track all costs related to capitalized internal-use software costs. To substantiate capitalization with your auditors, be sure to maintain payroll reports and related payroll benefit documentation, timesheets for employees who have directly worked on the project, invoices from outside vendors or service providers, and reports/workbooks to calculate and allocate the capitalized costs.

Contact Logan Rose or a member of your service team to discuss this topic further.

Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law with your professional advisers.

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