Under ASC 350-40, internal-use software capitalization begins only after two conditions are met at the same time: management with the relevant authority authorizes and commits to funding the project, and it becomes 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 spent before that point is expensed. Capitalization stops the moment the software is ready for its intended use, and costs after that point are expensed again. The narrow window between those two markers is where the asset is built, and where most of the judgment calls and audit disputes live.
Which Software Is in Scope
The standard applies to 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 – Intangibles – Goodwill and Other – Internal-Use Software (Subtopic 350-40) If the system runs payroll, manages inventory, or tracks customers, you are in scope. Software you plan to sell to customers follows different guidance, and software embedded in equipment you manufacture is generally rolled into the equipment cost rather than treated as a standalone software asset.
One exclusion catches people off guard. Software built purely for research and development is expensed immediately under ASC 730, no matter how far along the build is.3Internal Revenue Service. FAQs – IRC 41 QREs and ASC 730 LBI Directive If a project begins as R&D and later shifts to internal operational use, capitalization starts only once that transition happens and the two conditions above are met.
Website development costs historically sat in their own subtopic, ASC 350-50. Once ASU 2025-06 takes effect, they move into the ASC 350-40 framework and follow the same capitalization rules as any other internal-use software.1Financial Accounting Standards Board (FASB). FASB Issues Standard That Makes Targeted Improvements to Internal-Use Software Guidance
The Three Stages That Control Timing
Through fiscal years beginning on or before December 15, 2027, every project is split into three sequential stages, and the stage you are in controls whether costs land on the balance sheet or the income statement.
Preliminary Project Stage
This covers everything before real commitment: evaluating alternatives, sketching concepts, comparing vendors, running feasibility studies, deciding whether to proceed at all. Every cost here is expensed as incurred. Many projects die at this stage, and capitalizing their costs would put fictitious assets on the balance sheet. The stage ends when management formally authorizes and commits to funding the project.
Application Development Stage
This is the capitalization window. It opens when the two conditions are met at the same time, and once they are, capitalizing qualifying costs is required, not optional. Capitalizable activities include detailed program design, coding, building interfaces to other systems, installing hardware needed to run the software, and substantial testing. For purchased software packages, the window opens when the entity begins customizing the package and closes when the customized package is ready for use. License fees to a vendor are capitalized when acquired.
The window closes when all substantial testing is complete and the software is ready for its intended use. That phrase does the heavy lifting. It does not mean every user has been trained or every known bug has been fixed. It means the software can perform the functions it was designed for. Once you reach that point, capitalization stops immediately, even if you choose to delay the actual rollout.
Post-Implementation Stage
After the software is ready for its intended use, every cost is expensed. Routine maintenance, bug fixes, ongoing support, and small tweaks all hit the current period. The one exception worth flagging is a major upgrade that delivers significant new functionality: those enhancement costs can start a new capitalization cycle, but only if they independently satisfy the same two-condition test. An upgrade that merely preserves current performance does not qualify. The line between enhancement and maintenance is contested in practice, and auditors tend to look at it carefully.
Costs You Can Capitalize
Only costs directly attributable to the build during the application development stage qualify, and they must be incremental to the project. If the cost would have been incurred anyway, it does not go on the asset.
- Internal labor, including wages, benefits, and payroll taxes for employees whose time is tracked directly to the project, such as developers, database administrators, and project managers. Rough allocations of a share of someone’s salary do not meet the standard.
- External services from third-party consultants, contractors, or vendors who write code, perform integration, or carry out other application development work.
- Materials and services consumed during development, such as testing environments or development tools purchased for the project.
- Interest costs during the development period, which 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 limited to the actual interest incurred.
Costs That Stay on the Income Statement
Several categories are barred from capitalization at every point in the project. Training is the big one. Whether it happens during development or after go-live, training is always expensed, because the entity cannot control whether trained employees stay.
General and administrative overhead is also excluded. You cannot load the asset with a share of office rent, utilities, or the CFO’s salary. Marketing, advertising, and selling costs tied to the software are similarly barred. These exclusions prevent the capitalized asset from being padded with costs that would have existed anyway.
Data Conversion Is a Common Trap
Data conversion is one of the most frequently misclassified categories. The general rule is that conversion costs are expensed as incurred, including cleaning existing data, reconciling old and new data sets, creating new records, and migrating data from the old system to the new.4Financial Accounting Standards Board (FASB). Proposed ASU – Targeted Improvements to the Accounting for Internal-Use Software
The narrow exception: if you develop or purchase software specifically to let the new system 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 into the new system is not. Large ERP implementations often involve both on the same project, so careful cost segregation matters.
Cloud and SaaS Implementation Costs
For cloud-hosted software, the treatment depends on whether the arrangement includes a software license. When the arrangement is purely a service contract and the vendor hosts and controls the software, you do not own a software asset and subscription fees are expensed as incurred. ASU 2018-15 requires that implementation costs for these hosting arrangements follow the same capitalization rules as internal-use software under ASC 350-40.5Financial Accounting Standards Board (FASB). Accounting Standards Update 2018-15 – Intangibles – Goodwill and Other – Internal-Use Software (Subtopic 350-40): Customers Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement That Is a Service Contract
So if your team spends six months configuring and customizing a cloud platform before it goes live, those implementation costs run through the same three-stage analysis. Preliminary activities are expensed, application-development-equivalent activities are capitalized, and post-implementation activities are expensed. The capitalized implementation costs are then amortized over the term of the hosting contract, including renewal periods the entity is reasonably certain to exercise.
Presentation of the deferred implementation costs must line up with the subscription fees. If the subscription is an operating expense, the amortization of the implementation costs appears on 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 capitalization and amortization rules to it.
Amortization and Impairment After Go-Live
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 how quickly the technology is expected to become obsolete and by any contractual limits like license terms. Straight-line is most common, but the standard requires the method that best reflects how the economic benefits are consumed, so an accelerated method may fit a front-loaded usage pattern.
Capitalized software must be tested for impairment whenever events suggest the carrying amount may not be recoverable. Triggers include a significant shift in how the software is used, a decision to abandon a module, a major technology disruption, or a sharp contraction in the business unit that depends on it. The test runs under ASC 360-10: compare undiscounted future cash flows to the carrying amount, and if the asset fails, write it down to fair value. Once you take that write-down, you cannot reverse it later if conditions improve.
What Changes Under ASU 2025-06
FASB issued ASU 2025-06 in September 2025, and it is the most significant overhaul of ASC 350-40 since the original standard. The amendments are effective for fiscal years beginning after December 15, 2027, and interim periods within those fiscal years, 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 a calendar-year company, that mandatory date is January 1, 2028.
The headline change: the three-stage model goes away entirely. All references to the preliminary project stage, application development stage, and post-implementation stage are removed.1Financial Accounting Standards Board (FASB). FASB Issues Standard That Makes Targeted Improvements to Internal-Use Software Guidance FASB made this change so the guidance would work for agile and iterative development, where teams do not move linearly from design to coding to testing.
Under the new model, capitalization is driven by the same two conditions that currently define the application development stage: management authorizes and commits to funding the project, and it is probable the project will be completed and the software will be used as intended. The update then adds a new layer called “significant development uncertainty.” If the software involves technological innovations or novel features whose uncertainty has not been resolved through coding and testing, capitalization must be deferred until that uncertainty is resolved.2Financial Accounting Standards Board (FASB). Accounting Standards Update 2025-06 – Intangibles – Goodwill and Other – Internal-Use Software (Subtopic 350-40) The update also folds website development costs into the unified ASC 350-40 framework. Entities adopting early or transitioning in 2028 can choose a prospective, modified retrospective, or full retrospective transition method.
Book vs. Tax: Section 174 Diverges
The GAAP rules under ASC 350-40 and the federal tax rules are not the same, and the gap has widened since 2022. For book purposes, you capitalize during the application development stage and amortize over a useful life you estimate. For tax purposes, Section 174 of the Internal Revenue Code now requires all domestic research and experimental expenditures, including software development costs, to be capitalized and amortized ratably over five years.6GovInfo. 26 U.S.C. 174 – Amortization of Research and Experimental Expenditures Foreign research expenditures must be amortized over fifteen years.
Before 2022, companies could elect to deduct Section 174 costs immediately. That option is gone. The five-year amortization applies regardless of how the costs are treated for book purposes, which means almost every entity with software development activity now carries a book-tax difference that has to be tracked for deferred tax purposes. Amortization begins when the research first provides benefits to the company, not when the software is placed in service.
The covered costs under Section 174 are broad: planning, designing, building models, writing code, and testing up through internal deployment or development of product masters for external sale. That overlaps heavily with what you capitalize under ASC 350-40, but the periods rarely match. Even a software asset you amortize over five years for book might also amortize over five years for tax while the start dates and cost bases differ, generating temporary differences that run through your deferred tax accounts.