Internally developed software

Welcome to Internally Developed Software!

Hello there! Ready to dive into one of the most practical parts of the BAR exam? In today’s world, almost every company is a "tech company" in some way. Whether a business is building an app to sell to customers or just creating a custom portal for its employees to track their hours, they are spending money on internally developed software.

As a CPA, your job is to figure out: "Is this an expense that hits the income statement immediately, or is it an asset we can put on the balance sheet and spread out over time (capitalization)?" Don't worry if this seems tricky at first—we’re going to break it down stage by stage!

1. The Two Main Paths

Before we look at the numbers, we have to ask: Who is the software for? The accounting rules change depending on the answer.

• A hosting arrangement contains a software license only if the customer can take possession at any time without significant penalty and can feasibly run it on its own hardware or with an unrelated host. Otherwise it is a service contract. For service arrangements, expense hosting fees as received; evaluate implementation costs under the applicable version of ASC 350-40 rather than capitalizing every implementation cost. A SaaS provider’s software is not automatically external-sale software merely because customers pay for access; assess whether a software license is transferred.

A hosting arrangement contains a software license only if the customer can take possession at any time without significant penalty and can feasibly run it on its own hardware or with an unrelated host. Otherwise it is a service contract. For service arrangements, expense hosting fees as received; evaluate implementation costs under the applicable version of ASC 350-40 rather than capitalizing every implementation cost. A SaaS provider’s software is not automatically external-sale software merely because customers pay for access; assess whether a software license is transferred.

2. Internal Use Software (ASC 350-40)

State which internal-use software guidance applies. Before adoption of ASU 2025-06, ASC 350-40 uses project stages, with qualifying application-development costs capitalized and preliminary, training and maintenance costs generally expensed. ASU 2025-06 removes the stage model; capitalization begins when management authorizes and commits funding and completion and intended use are probable, considering significant development uncertainty. It is effective for annual periods beginning after December 15, 2027, with early adoption permitted.

Stage 1: Preliminary Project Stage

This is the "brainstorming" phase. You are looking at alternatives, choosing vendors, and deciding if the project is even possible.
Accounting Treatment: EXPENSE everything. At this point, we aren't sure if a "deck" will ever actually exist.

Stage 2: Application Development Stage

State which internal-use software guidance applies. Before adoption of ASU 2025-06, ASC 350-40 uses project stages, with qualifying application-development costs capitalized and preliminary, training and maintenance costs generally expensed. ASU 2025-06 removes the stage model; capitalization begins when management authorizes and commits funding and completion and intended use are probable, considering significant development uncertainty. It is effective for annual periods beginning after December 15, 2027, with early adoption permitted.

Stage 3: Post-Implementation/Operation Stage

The software is live! Now you are just doing routine maintenance and training employees.
Accounting Treatment: EXPENSE everything. Training and maintenance do not "improve" the asset; they just keep it running.

Did you know? Training costs are always expensed, even if they happen during the development stage. You can't capitalize a human's knowledge!

3. Software to be Sold, Leased, or Marketed (ASC 985)

When software is the product, the rules get a bit stricter. The big "turning point" here is a concept called Technological Feasibility.

The "Before" and "After" of Technological Feasibility

Technological Feasibility is established when you have a detailed program design or a working model. It means you’ve proven the software can actually do what it’s supposed to do.

• Before Technological Feasibility: All costs are considered Research & Development (R&D) and must be EXPENSED.
• After Technological Feasibility (until the product is released): Costs are CAPITALIZED as an inventory-like asset.
• After General Release to Customers: Stop capitalizing. New costs are now production costs or maintenance.

Amortizing External Software

Once the software is sold, you must amortize (expense) the capitalized costs. You must use the greater of two calculations:

1. Percentage of Revenue Method: \( \text{Total Capitalized Cost} \times \left( \frac{\text{Actual Revenue for Period}}{\text{Total Expected Revenue}} \right) \)
2. Straight-Line Method: \( \frac{\text{Total Capitalized Cost}}{\text{Remaining Economic Life}} \)

Example: If the Revenue method gives you \$10,000 and the Straight-Line method gives you \$12,000, you must record \$12,000 in amortization expense. The goal is to be conservative and not overstate the asset's value.

4. Cloud Computing Arrangements (SaaS)

A hosting arrangement contains a software license only if the customer can take possession at any time without significant penalty and can feasibly run it on its own hardware or with an unrelated host. Otherwise it is a service contract. For service arrangements, expense hosting fees as received; evaluate implementation costs under the applicable version of ASC 350-40 rather than capitalizing every implementation cost. A SaaS provider’s software is not automatically external-sale software merely because customers pay for access; assess whether a software license is transferred.

5. Summary Table & Key Takeaways

To keep it simple, look at this "Cheat Sheet":

Common Mistake to Avoid: Don't confuse "Technological Feasibility" (External Use) with "Management Commitment" (Internal Use). The BAR exam loves to swap these terms to trip you up!

Key Takeaway:

State which internal-use software guidance applies. Before adoption of ASU 2025-06, ASC 350-40 uses project stages, with qualifying application-development costs capitalized and preliminary, training and maintenance costs generally expensed. ASU 2025-06 removes the stage model; capitalization begins when management authorizes and commits funding and completion and intended use are probable, considering significant development uncertainty. It is effective for annual periods beginning after December 15, 2027, with early adoption permitted.

Keep going! Accounting for software might feel "intangible," but once you master the timing of these stages, you'll be coding your way to a passing score!