Internal Use Software – Determining Which Accounting Guidance to Use

In the last decade, the cloud computing industry has grown exponentially. Software-as-a-service (SaaS) platforms are currently dominating the industry, and internal use software offerings and methods of delivery are continuously evolving. Despite these sweeping changes, accounting guidance has had no major changes. As a result, people are often confused on how to account for the cost of developing a SaaS product in accordance with U.S. Generally Accepted Accounting Principles (GAAP). Entities continuously question whether they should follow ASC 350-40: Internal-Use Software or ASC 985-20: Costs of Software to Be Sold, Leased or Marketed. In most cases, SaaS companies should follow ASC 350-40.

ASC 350-40: Internal-Use Software applies to software acquired, internally developed, or modified solely to meet the entity’s internal needs. Additionally, to qualify for the internal use software rules, the entity is not allowed to plan on marketing the software externally at any time. This tends to confuse GAAP users, as the guidance does not explicitly define what it means to “market the software externally.” Many people assume that if the entity plans on generating revenue using the software then ASC 350-40 is not applicable. However, marketing the software externally does not include cloud-based arrangements where the entity hosts the software and the customer accesses the platform for a period of time. SaaS platforms that are hosted by the vendor fall within the scope of ASC 350-40 and the cost of developing the platform should be considered for capitalization. To learn more on how to apply this guidance, please read the blog, Accounting for Development Costs of Internal-Use Software.

In order to determine the applicable accounting guidance, one needs to determine which entity will host the SaaS platform. If the vendor is contractually obligated to host the platform, then the costs of development should generally be accounted for using ASC 350-40. If the customer is contractually allowed to and has the ability to host the platform, then the cost of development should generally be accounted for by the vendor using ASC 985-20.

Each section of guidance will produce different financial results, so it is important that the correct one is used. ASC 985-20 permits entities to capitalize development costs only when the software can function as intended, also referred to as the point of technological feasibility. Once the software is in use, any additional costs must be expensed. The period of time between when the software functions as intended to when it is in use is generally very short. As a result, typically no amounts are ever capitalized related to this type of software. When software development falls under ASC 350-40, the costs are able to be capitalized during the application development stage. Therefore, there can be significant costs capitalized. For more information, please read Accounting for Development Costs of Internal-Use Software.

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