Under the ASC 350-40 capitalization rules, internal-use software costs begin going to the balance sheet only when two conditions are met at the same time: management with the relevant authority has authorized and committed to funding the project, and it is probable the software will be completed and used as intended.1Financial Accounting Standards Board (FASB). FASB Issues Standard That Makes Targeted Improvements to Internal-Use Software Guidance Everything before that point is expensed. Everything after the software is ready for its intended use is expensed. The window in between is narrow, and it is where most of the judgment calls live.
What Software Is In Scope
ASC 350-40 covers software an entity develops or acquires for its own internal operations, with no plan to sell, lease, or market it externally.2Financial Accounting Standards Board (FASB). Accounting Standards Update 2025-06 Payroll systems, inventory management, CRM platforms, internal reporting tools all qualify. Software that is part of a product or service you sell falls under ASC 985-20 instead. Software embedded in equipment you manufacture and sell is generally treated as part of the equipment cost.
One boundary catches people out: software developed purely for research and development activities is expensed under ASC 730, no matter how far the build has progressed.3Internal Revenue Service. FAQs – IRC 41 QREs and ASC 730 LBI Directive If an R&D project later shifts to operational use, capitalization can begin only once the R&D phase ends and the two-condition test is met.
The Three Stages That Gate Capitalization
Through fiscal years beginning on or before December 15, 2027, ASC 350-40 splits every project into three sequential stages. The stage determines the accounting.
Preliminary Project Stage
This covers everything before real commitment: evaluating alternatives, comparing vendors, sketching concepts, running feasibility studies, and management time spent deciding whether to proceed. All of it is expensed as incurred. Many projects die here, and capitalizing them would put fictitious assets on the balance sheet. The stage ends when management formally authorizes the project and commits to funding it.
Application Development Stage
This is the capitalization window. It opens the moment both conditions are satisfied: authorized funding and probable completion.1Financial Accounting Standards Board (FASB). FASB Issues Standard That Makes Targeted Improvements to Internal-Use Software Guidance Once both are met, capitalization is required, not optional.
Qualifying activities include detailed program design, coding, developing interfaces to other systems, installing hardware needed to support the software, and substantial testing. For a purchased software package, the window opens when the entity begins customizing it and closes when the customized package is ready for use. License fees paid to a vendor are capitalized on acquisition.
The window shuts when substantial testing is complete and the software is ready for its intended use. That phrase controls the timing. It does not mean the software is perfect or that users have been trained. It means the software can perform the functions it was designed for. Once you hit that point, capitalization stops, even if the actual rollout is delayed.
Post-Implementation Stage
Everything after ready-for-use is expensed as incurred: routine maintenance, bug fixes, minor tweaks, ongoing support. The one exception is a major upgrade or enhancement that delivers significant new functionality, which can start a fresh capitalization cycle if it independently satisfies the same two-condition test. An upgrade that only preserves existing performance is maintenance. The line between enhancement and maintenance is contentious, and auditors look at it closely.
Which Costs You Can Capitalize
Only costs directly attributable to the development effort during the application development stage qualify. The eligible categories are narrower than most entities assume.
- Internal labor: wages, benefits, and payroll taxes for employees whose time is spent directly on the project, such as developers, database administrators, and project managers. Time has to be tracked to the project; rough allocations of a share of someone’s salary do not hold up.
- External services: fees paid to third-party consultants, contractors, or vendors performing coding, integration, or other application development work.
- Materials and services consumed during development, such as testing environments or development tools purchased solely for the project.
- Interest costs incurred during the development period may be capitalized under ASC 835-20 if the project qualifies as an asset requiring a substantial period to get ready for use. The capitalized amount is capped at actual interest incurred during the period.
Every capitalized cost has to be incremental to the project. If you would have incurred it anyway, it does not qualify.
Costs You Cannot Capitalize, Ever
Some categories are barred from capitalization regardless of stage. Training costs are the biggest one. Whether training happens during development or after go-live, it is expensed as incurred, because the entity cannot control whether trained employees stay long enough to deliver a future benefit.
General and administrative overhead is also excluded. You cannot load the software asset with a slice of office rent, utilities, or executive salaries. Marketing, advertising, and selling costs tied to the software are barred as well. These exclusions exist to keep entities from inflating the asset with costs that would have existed regardless of the project.
Data Conversion Is a Common Trap
Data conversion costs are expensed as incurred. That covers cleaning existing data, reconciling old and new data sets, creating new records, and migrating data from the old system to the new one. The narrow exception: if you develop or purchase software specifically to allow the new system to access or convert old data, the cost of that conversion software is capitalizable.4Financial Accounting Standards Board (FASB). Proposed ASU – Targeted Improvements to the Accounting for Internal-Use Software Building a bridge application that translates data formats between systems is a capitalizable software cost. Hiring temps to re-key records is not. Large ERP implementations routinely involve both, so careful cost segregation matters.
Cloud Arrangements and SaaS Implementation Costs
If the software is cloud-hosted and the vendor controls it, you do not own a software asset, and the subscription fees are expensed as incurred. ASU 2018-15 requires that implementation costs for these hosting arrangements follow the same capitalization rules as ASC 350-40.5Financial Accounting Standards Board (FASB). Accounting Standards Update 2018-15 So six months of configuration and customization work before go-live runs through the same three-stage analysis: preliminary activities expensed, application-development-equivalent activities capitalized, post-implementation expensed.
The capitalized implementation costs are amortized over the term of the hosting contract, including renewal periods the entity is reasonably certain to exercise. Presentation has to line up with the subscription fees. If the subscription runs through operating expense, the amortization of capitalized implementation costs goes to the same line. When the arrangement does include a software license the customer controls, the entity recognizes an intangible asset and applies standard ASC 350-40 rules.
Amortization and Impairment
Once the software is ready for use, the capitalized cost is amortized over its estimated useful life. Most entities land between three and seven years, driven by expected obsolescence and any contractual limits like license terms. Straight-line is the common method, though the standard calls for whichever pattern best reflects how the economic benefits are consumed. Disclosures follow the property, plant, and equipment requirements of ASC 360-10 rather than the intangible asset rules of ASC 350-30.
Impairment testing is triggered when events suggest the carrying amount may not be recoverable: a significant shift in how the software is used, abandonment of a module, a technology disruption that reduces its usefulness, or a sharp contraction in the business unit that depends on it. The test under ASC 360-10 first compares undiscounted future cash flows to carrying amount. If the asset fails, the loss equals the difference between carrying value and fair value. Once written down, a software asset cannot be written back up if conditions later improve.
What Changes Under ASU 2025-06
FASB issued ASU 2025-06 in September 2025, effective for fiscal years beginning after December 15, 2027, with early adoption permitted at the start of any annual reporting period.1Financial Accounting Standards Board (FASB). FASB Issues Standard That Makes Targeted Improvements to Internal-Use Software Guidance For calendar-year filers, the mandatory start date is January 1, 2028.
The three-stage model goes away. ASU 2025-06 removes all references to the preliminary project stage, application development stage, and post-implementation stage, because mapping agile and iterative sprints onto a linear sequence produced inconsistent results in practice. Capitalization is instead driven solely by the same two conditions that currently define the application development stage: authorized funding and probable completion.
The update adds a wrinkle: “significant development uncertainty.” If the software involves technological innovations or novel features whose uncertainty has not been resolved through coding and testing, capitalization is deferred until that uncertainty is resolved.2Financial Accounting Standards Board (FASB). Accounting Standards Update 2025-06 The update also folds website development costs (formerly ASC 350-50) into the unified ASC 350-40 framework. Entities can transition prospectively, modified retrospectively, or fully retrospectively.
Tax Treatment Diverges Sharply
The GAAP answer under ASC 350-40 does not carry over to your tax return. Section 174 of the Internal Revenue Code now requires all domestic research and experimental expenditures, including software development costs, to be capitalized and amortized over five years.6GovInfo. 26 U.S.C. 174 – Amortization of Research and Experimental Expenditures Foreign research expenditures amortize over fifteen. The pre-2022 option to deduct these costs currently is gone.
The Section 174 definition is broad: planning, designing, building models, coding, and testing through internal deployment. That overlaps heavily with what you capitalize under ASC 350-40, but the amortization periods and start dates rarely align, so nearly every entity with software development activity now carries a book-tax difference to track for deferred tax purposes. The Section 174 amortization begins when the research first provides benefits, not when the software is placed in service.