On September 18, 2025, FASB issued Accounting Standards Update (ASU) 2025-06, Targeted Improvements to the Accounting for Internal-Use Software, which updates the evaluation criteria used to determine when the capitalization of internal-use software costs should begin. This article will explore the standard, which is effective for all entities for annual reporting periods beginning after December 15, 2027 and interim reporting periods within those annual periods. Early adoption is permitted.
Background
As companies increasingly look to disrupt traditional product and service offerings with technology, understanding the proper accounting treatment for the capitalization of software costs is important. The amendments in this ASU apply to all entities subject to the guidance in Accounting Standards Codification (ASC) 350-40, Intangibles—Goodwill and Other—Internal-Use Software. The amendments also apply to all entities that account for website development costs in accordance with ASC 350-50, Intangibles—Goodwill and Other—Website Development Costs, with ASC 350-50 being superseded as a result of this amendment and the related guidance for website development costs now being incorporated into ASC 350-40. The amendments do not affect software costs subject to ASC 985-20, Software—Costs of Software to Be Sold, Leased, or Marketed (external-use software).
FASB issued this ASU in response to concerns that current guidance is outdated and no longer aligns with the agile software development approach most often used by technology companies. Stakeholders contended there were challenges in determining when to start capitalizing internal-use software costs, prompting FASB to update the guidance to consider different methods by which software development occurs.
The ASU is intended to improve the guidance around the determination of when an entity should begin capitalizing eligible software costs but does not change the types of costs that are eligible for capitalization. As a result of this amendment, FASB expects that capitalization of internal-use software costs generally will not change significantly for most types of software. For the development of software to be provided via a cloud computing arrangement, i.e., a Software as a Service (SaaS) arrangement, FASB expects the amendments could result in a decrease in software cost capitalization due to the fact that in many cases, there is significant development uncertainty with these types of arrangements until they are close to completion.
When a company is considering the accounting for costs incurred for software development, it is important to correctly identify the relevant standard. The determination of whether software is accounted for under Subtopic 350-40 or Subtopic 985-20 is not affected by the amendments in this ASU.
Many modern technology companies generate revenue by using their software in a SaaS arrangement. Technology developed for planned use in a SaaS arrangement represents internal-use software accounted for under ASC 350-40. If either of the following criteria are not met, then the software being developed is considered to be internal-use software:
1. The customer has the contractual right to take possession of the software at any time during the hosting period without significant penalty.
2. It is feasible for the customer to either run the software on its own hardware or contract with another party unrelated to the vendor to host the software.
The potential decrease in software capitalization for SaaS arrangements as a result of the amendments in ASU 2025-06 will more closely align with the accounting outcomes for the development of software sold via an on-premises license (under ASC 985-20). This may help establish greater consistency in financial reporting outcomes for software, whether it be developed for internal use or not.
Expenses Subject to Capitalization
While the ASU aims to improve guidance for when an entity starts capitalizing internal-use software costs, it does not change the type of expenses eligible for capitalization. Costs eligible for capitalization include:
- External direct costs of materials and services consumed in developing or obtaining internal-use computer software.
- Payroll and payroll-related costs, e.g., costs of employee benefits, for employees who are directly associated with and who devote time to the internal-use computer software project, to the extent of the time spent directly on the project.
- Interest costs incurred while developing internal-use computer software.
- Costs to develop or obtain software that allows for access to or conversion of old data by new systems.
General and administrative costs and overhead costs shall not be capitalized as costs of internal-use software.
Criteria for Capitalization in ASU 2025-06
The amendments in this ASU are meant to capture the evolution of how software is developed, moving from a linear development process to the current environment where companies are using a more agile or iterative development approach. To adapt to the new environment, all references to sequential software development methods have been removed and instead an entity will be required to start capitalizing eligible costs for a software project when both of the following occur:
- Management has authorized and committed to funding the software project.
- It is probable that the project will be completed and the software will be used to perform the function intended (known as the “probable-to-complete recognition threshold”).
This ASU provides new guidance on how to evaluate whether the probable-to-complete recognition threshold has been met. To determine whether the threshold has been met, an entity is required to consider whether there is significant development uncertainty associated with the activities of the software. There are two factors, if present, that indicate significant development uncertainty exists:
- The software being developed has technological innovations or novel, unique, or unproven functions or features, and the uncertainty related to those technological innovations, functions, or features, if identified, has not been resolved through coding and testing.
- The significant performance requirements of the software have not been identified, or the identified significant performance requirements continue to be substantially revised.
The amendments in this ASU define “performance requirements” as what an entity needs the software to do, e.g., functions or features. That definition is consistent with how performance requirements have historically been described in the FASB Master Glossary definition of the term “preliminary project stage.”
Entities will need to use judgment in determining how to apply these concepts to their specific facts and circumstances, including when significant development uncertainty exists and how and when it is resolved. Internal and external costs incurred prior to meeting the requirements for capitalization shall be expensed as they are incurred.
FASB noted in the Basis for Conclusions of this ASU that for certain internal-use software projects, such as enterprise resource planning (ERP) implementations that use a developed solution, an entity may be able to conclude that the probable-to-complete threshold has been met without the need to evaluate whether significant development uncertainty is present.
FASB also noted that in gathering stakeholder feedback, some comment letter respondents expressed concerns about the level of judgment required to evaluate significant development uncertainty. Capitalization of software development costs is required when the related criteria are met and there is no election available to unilaterally expense such costs. However, it is acknowledged that the application of the standard requires judgment to determine whether and when an entity capitalizes software costs. As a result, some entities may have different financial reporting outcomes for similar facts and circumstances.
This guidance presents practical challenges for technology companies in evaluating which software development costs qualify for capitalization. Early-stage technology companies developing new software for use in a SaaS platform are often pursuing new technological innovations or novel, unique, or unproven functions or features.
For example, an early-stage medical technology company has approved and committed to funding a project to develop a novel artificial intelligence (AI)-powered imaging analysis software to be used to assist physicians by supplementing traditional diagnostic methods. Given the novel nature of the software, the technology necessary for providing diagnostic functionality does not exist and the company will need to incur substantial internal and external costs to develop it. In addition, identified significant performance requirements continue to be substantially revised.
A project such as this will not meet the criteria for capitalization until the significant performance requirements have been identified and the company has completed the coding and testing necessary to demonstrate that the functionality can perform the intended task. In practice, there may often be a limited amount of time between when capitalization of costs begins and ends, after all substantial testing is completed.
Accounting for costs incurred for repairs, upgrades, and enhancements are not impacted by this ASU. FASB defines upgrades and enhancements as modifications to existing internal-use software that result in additional functionality, i.e., modifications to enable the software to perform tasks that it was previously incapable of performing. Costs incurred for upgrades and enhancements shall be expensed or capitalized consistent with the criteria for other development costs as detailed above. Costs incurred that do not result in additional functionality are considered to be maintenance and shall be expensed as incurred.
Consistent with historical guidance, ASC 350-40 will continue to permit entities that cannot separate internal costs on a reasonably cost-effective basis between maintenance and relatively minor upgrades and enhancements to expense such costs as incurred.
Companies that are required to capitalize material amounts of software development costs often require meaningful investments to implement accounting policies and systems to track such costs at a sufficient level of detail. However, as noted within the example above, given the potentially limited amount of time between when capitalization of costs begins and ends for novel technological innovations, a company may conclude that no material costs are required to be capitalized. In addition, these companies may not have the ability to separate subsequent maintenance costs from those of relatively minor upgrades and enhancements on a reasonably cost-effective basis and are accordingly permitted to expense all such costs as incurred.
These outcomes are highly dependent on judgments made as part of the evaluation of such costs and related capitalization requirements detailed herein. We encourage companies to proactively consult with their accounting advisors and auditors regarding these potential outcomes.
Required Presentation & Disclosure
Under this ASU, the disclosure requirements found in ASC 360-10, Property, Plant, and Equipment—Overall, apply to capitalized costs under ASC 350-40, regardless of how the expenses appear in the financial statements. Any disclosures in ASC 360-10 related to property, plant, and equipment should be applied to internal-use software costs and related amortization.
Entities will be required to disclose the capitalized internal-use software balance and accumulated amortization at the balance sheet date, the amortization expense for the period, and a general description of the method used in computing amortization.
Companies should also continue to include a line item in the statement of cash flows for amortizing capitalized software.
In addition, as applicable, disclosures should be made in accordance with ASC 275, Risks and Uncertainties; ASC 730-10, Research and Development—Overall; and ASC 235, Notes to Financial Statements.
A key presentation distinction for companies that capitalize software development is the impact on EBITDA, defined as earnings before interest, taxes, depreciation, and amortization. EBITDA is often analyzed by users of financial information to evaluate a company’s profitability from operations exclusive of capital structure and tax effects. In addition, EBITDA is commonly used as a valuation metric when determining enterprise value (EV) multiples such as EV/EBITDA for comparing companies in mergers, acquisitions, and investment analysis.
When a company is required to capitalize software development costs, the subsequent amortization is typically treated as an add-back when calculating EBITDA. However, when such costs are not capitalized, they are expensed as incurred, reducing net income during the current period as well as eliminating the potential add-back to EBITDA in future periods.
In gathering stakeholder feedback, FASB noted that some investors expressed concern that capitalizing and amortizing expenditures incurred in the development of revenue-producing software would not faithfully represent the economic activity of developing software for sale to customers and would make key performance metrics such as EBITDA less decision-useful.
Transition
The amendments in this ASU permit an entity to apply the new guidance using any of the following transition approaches:
- A prospective transition approach
- A modified transition approach
- A retrospective transition approach
Under a prospective transition approach, an entity should apply the amendments in this ASU to new software costs incurred as of the beginning of the period of adoption for all projects, including in-process projects.
Under a modified transition approach, an entity should apply the amendments in this ASU on a prospective basis to new software costs incurred (for all projects, including costs incurred for in-process projects), except for in-process projects that, as of the date of adoption, the entity determines do not meet the capitalization requirements under the amendments but met the capitalization requirements under historical guidance. For those in-process projects, an entity should derecognize any capitalized costs through a cumulative-effect adjustment to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) as of the date of adoption.
Under a retrospective transition approach, an entity should recast comparative periods and recognize a cumulative-effect adjustment to the opening balance of retained earnings (or other appropriate components of equity or net assets in the statement of financial position) as of the beginning of the first period presented.
Conclusion
Nearly all companies use software for operations or delivering services, making software cost accounting widely applicable. Although ASU 2025-06 better aligns the accounting requirements with modern software development methodologies, determining which accounting model to apply and what development costs require capitalization is complex and requires significant judgment.
Our Assurance and Accounting Advisory & Financial Reporting teams at Forvis Mazars can help businesses navigate and implement FASB guidance. Our proactive approach includes candid and open communication to help address your financial reporting needs. If you have questions or need assistance, please reach out to one of our professionals.