FASB Proposes New Software Accounting Rules to Reflect Modern Development Methods

In a significant move to bring accounting practices in line with modern technology, the FASB on October 29, 2024, proposed changes to the way companies account for internal-use software costs.

The current system, criticized for being outdated and complex, has led to diverse practices and opaque reporting. The proposed changes seek to replace rigid project-stage guidelines with a more agile approach that mirrors modern software development.

This shift is expected to reduce ongoing costs, improve transparency, and provide investors with a clearer picture of a company’s software costs, the board said. Specifically, companies may see more consistent financial reporting, reduced diversity in practice, and easier application of guidance across different software development methods.

“During our 2021 agenda consultation, stakeholders expressed the desire for updated accounting guidance that better aligns with how software is developed,” said FASB Chair Richard Jones in a statement. “The FASB’s proposed changes are intended to improve the operability of the recognition guidance considering different methods of software development.”

The board is now seeking feedback from the public on whether the changes—released in Proposed Accounting Standards Update (ASU) No. 2024-ED400, Intangibles—Goodwill and Other—Internal-Use Software (Subtopic 350-40), Targeted Improvements to the Accounting for Internal-Use Software —would be operable.

Comments are due by January 27, 2025.

Most Costs Expensed?

The proposal, which isn’t a revamp of all software costs, acknowledges that there are different approaches to building software. Traditional methods, like the “waterfall” approach, follow a strict, step-by-step sequence, where each stage is completed before moving on to the next. In contrast, modern approaches like “agile development” and “iterative methods” are more flexible and adaptable. These methods involve breaking down the development process into smaller chunks, working on them in short cycles, and refining them based on feedback and changing requirements. This allows for faster adaptation to changes, improved collaboration, and more efficient use of resources.

As software development approaches evolve, accounting professionals are also re-evaluating how to handle software development costs. Weighing in on October 29, some agree that current accounting rules should be modernized, but caution that the FASB’s proposal may lead to more costs being expensed rather than capitalized. Expensing software costs lowers immediate profits but offers short-term tax benefits, while capitalizing spreads the cost over time, affecting financial statements and investor perceptions.

The proposed “‘probable-to-complete’ recognition threshold could become a barrier to capitalization resulting in software development costs increasingly being expensed,” said Allison Henry, VP of Professional & Technical Standards at the Pennsylvania Institute of CPAs. “There are also questions around how the guidance will address the evolving nature of software development, including revisions to the scope of the project and the related performance requirements,” she said. “While the proposed guidance would not require the entity to identify all performance requirements as a prerequisite for capitalization, assessing which performance requirements are significant could entail a degree of professional judgment.”

Modernizing Old Rules

The board proposed to:

• remove references to traditional, sequential software development methods (like the waterfall method) and introduce a more flexible approach that aligns with current iterative methods, such as agile development. This change reflects how software development has evolved.
• require business entities to start capitalizing software costs when management authorizes and commits to funding the project, and it is probable the project will be completed and used as intended. This “probable-to-complete recognition threshold” would replace the previous focus on specific project stages, making the guidance more adaptable to modern, iterative software development methods. This change is aimed at improving consistency and relevance in financial reporting, aligning accounting practices with how software is currently developed.
• require business entities to present cash paid for capitalized internal-use software costs separately as investing cash outflows in financial statements, enhancing transparency for investors.
• integrate the guidance for website development costs into the internal-use software guidance, simplifying the accounting process.

The proposal also offers entities flexibility in implementing the new guidance, allowing them to choose between a prospective or retrospective transition approach.

Under the prospective approach, entities would apply the amendments to software costs incurred during annual reporting periods (and interim periods within those annual periods) starting from the effective date, including costs incurred after the effective date for ongoing projects.

Alternatively, entities opting for the retrospective approach would recast comparative periods and recognize a cumulative-effect adjustment to the opening balance of retained earnings (or other relevant equity or net asset components) as of the beginning of the first period presented.