FASB plans for New Accounting Rules for Software Costs removing from balance sheet for companies that internally use it

Posted June 20, 2024

In today’s economy, software development costs represent a significant portion of many companies’ operating budgets. The method a company uses to account for these costs—whether expensing them as regular business costs or capitalizing them as investments in company assets—can greatly impact the bottom line. Deciding which costs to capitalize and which to expense is a critical financial and accounting decision for company management. Crowe LLP has an informative article about the different capitalization models ASC 985-20 and ASC 350-40 of the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) frameworks.

Examples of software developed for purposes of supporting internal operations:

Manufacturers that implement their own robotic production software
Banks that develop online banking tools or loan management systems
Healthcare organizations that develop or enhance various software applications including electronic patient records, telemedicine platforms, appointment scheduling, billing, and practice management systems
Sales organizations that develop or enhance their account management and customer relations software
Companies of all types that develop customized software to process payroll, manage payables and receivables, track inventory, or perform various other management and operational functions

In December of 2023, the Wall Street Journal reported that traditional accounting and disclosure rules for software costs, unchanged since the 1980s and 1990s, might see significant updates. Currently, companies follow two different models depending on whether they develop software or use it in their operations. PWC, explains that accounting for software and software-related costs is largely modeled after inventory guidance (for software that will be sold to customers) or fixed assets guidance (for software that will be used internally).

The Financial Accounting Standards Board (FASB) is considering a unified accounting model for all companies. This model would require companies to expense all direct software costs over time, starting when they determine that the completion of a software project is probable and continuing until the project is substantially completed.

Now in June, of 2024 the WSJ recently reported that U.S. companies might soon need to disclose cash amounts related to their software expenditures, which could be shifted off corporate balance sheets. The Financial Accounting Standards Board unanimously voted to propose a new accounting rule requiring companies to report these costs and clarify when to expense or capitalize them. This proposal represents a simplified approach to updating long-standing accounting rules regarding software expenses.

Understanding the Proposal

The Financial Accounting Standards Board (FASB) is proposing that U.S. public and private companies include a line item in their cash-flow statements for software spending. This proposal aims to update rules that have been largely unchanged since the 1980s and 1990s. It would apply to a wide range of software uses, such as enterprise resource planning systems, hosting services, and mobile banking applications, but would exclude software developed for licensing to customers.

The new plan simplifies current requirements by eliminating the need for companies to evaluate the stage of their software projects to determine whether to expense or capitalize costs. Presently, companies must expense software costs during initial planning and post-implementation stages and capitalize eligible costs during development. These rules require significant judgment and lead to higher compliance costs.

Under the proposed changes, companies would only need to start capitalizing software costs based on executive approval of a project and the likelihood of its completion and intended use. FASB Chairman Rich Jones supports the move, stating it aims to reduce the amount of software costs on the balance sheet.

If companies are uncertain about completing a software project, they would need to address significant development uncertainties, such as unproven or unique software features, before capitalizing related costs. Until these issues are resolved, development costs would be expensed on the income statement, similar to research and development expenses, rather than being capitalized as assets on the balance sheet. While current U.S. accounting rules already include this concept, the proposal would explicitly state that costs should not be reported as assets when uncertainties exist.

These changes would accommodate agile development, a popular approach where companies incorporate user feedback early to improve product features. The Financial Accounting Standards Board (FASB) plans to issue a formal proposal by the end of the year and will seek public feedback over a 90-day period.

Why should companies care?

Many companies struggle to apply the existing model for internal software use because they lack a tracking system to determine their project’s stage. The new proposal aims to simplify this process and reduce the effort required to track software costs.

Currently, there are two different accounting models based on whether a company develops software or uses it in its business. The proposal suggests moving to a single accounting model. Some tech companies, like Autodesk, have faced challenges with the current rules. In a 2021 letter to the Financial Accounting Standards Board (FASB), Autodesk’s Chief Accounting Officer, Stephen Hope, highlighted the undue complexity and misalignment of existing guidance with accounting for revenue-generating software development practices. Some tech companies were hoping for new accounting rules on licensing software.

Investor perspectives and concerns

Investors seek greater recognition of software and other intangible assets but worry about the potential for abuse if the FASB allows companies to defer more costs. Sandy Peters, senior head of advocacy at the CFA Institute, emphasized that while there is a need for stronger disclosures for companies developing software, there is also a risk that executives might misuse the ability to defer costs. She noted that current disclosures don’t provide investors with enough information to confidently evaluate management’s assumptions about cost deferrals.

Scaled back version

The proposed changes represent a significant shift from when the FASB first added the project to its agenda in 2022. Initially, the board considered a single accounting model requiring all companies to expense their direct software costs over time, from the point a project’s completion seemed probable until its substantial completion.

However, in March, the FASB decided against changing the accounting rules for companies developing software for license or sale. Instead, the new rule will focus on improving accounting for internal use software, reflecting investor feedback that showed little interest in significantly increasing capitalization.

FASB board member Christine Botosan noted the inconsistency in accounting rules depending on how the product is delivered to customers but acknowledged that the new proposal indirectly addresses this issue for many companies.

Conclusion

Many tech company management teams would prefer to expense all software development costs to avoid the recordkeeping and administrative burden of capitalization. However, U.S. GAAP requires that certain software development costs be capitalized, and companies must determine which ASC subtopics to apply for proper accounting.