The Difference Between Capitalizing Internal- and External-Use Software
July 07, 2017
By Fred Kosnac, CPA
In my previous blog, I discussed “The 3 Stages of Capitalizing Internally Developed Software.” Here, we’ll review the differences between capitalizing internal-use vs. external-use software. External-use software is defined as software to be sold, leased or marketed.
Capitalizable costs for internal-use software include development labor as well as third-party costs for software development or purchase. Non-capitalizable costs include overhead, administrative, training and maintenance.
When it comes to amortization, internal-use software should be amortized over its useful life, which typically ranges from 2 to 5 years. Amortization should begin when the internal-use software is ready for its intended use rather than when it is to be placed in service.
There are several factors that may make internal-use software costs non-recoverable: (1) the software isn’t expected to perform as intended; (2) software use is expected to change significantly; (3) a significant change is made to the software; (4) the costs to develop or modify the software vastly exceed the expected amount; and (5) the software is no longer being used. In these situations, the company may need to write down (or completely write off) the cost of the software, along with any accumulated amortization recorded up to that point. The difference between the two is recorded as an impairment loss on the income statement.
For future work performed on internal-use software that’s been implemented, the costs to fix bugs and other maintenance-type work on existing software are not capitalizable. However, more substantial work is. When considering work on pre-existing internal-use software, ask: “Am I adding functionality?” For example: A company shouldn’t capitalize work on monthly system updates and bug fixes, but it most likely could capitalize the development costs when it adds functionality like video capability.
It’s worth noting that external-use software that is developed to be sold, leased or marketed falls under a completely different set of rules: ASC 985-20. The key here is to know when “technological feasibility” has been achieved. The guidance states it is established when “the entity has completed all planning, designing, coding and testing activities that are necessary to establish that the product can be produced to meet its design specifications including functions, features and technical performance requirements.” Often, technical feasibility would be marked by completion of a detailed program design or a working alpha version.
Costs prior to achieving technological feasibility are expensed as incurred. Once technological feasibility is achieved, you can capitalize certain costs, including overhead in some cases. Once the product is in the marketplace, the company can no longer capitalize the software costs. Similar to internal-use software, maintenance and customer support costs are expensed as incurred.
Amortization of this type of software should begin when the product is available to be distributed to customers. Like internal-use software, companies need to periodically evaluate the capitalized development costs for impairment. A company with internal-use software will generally begin capitalizing costs sooner than a company with external-use software, as technological feasibility tends to be achieved later in the development process.