What do Tesla cars, smart TVs and equipment used for making french fries have in common? The answer is embedded software, according to recent comments by Financial Accounting Standards Board (FASB) Vice Chair James Kroeker. He also told the Private Company Council that today’s mixed accounting model for software costs is outdated and should be modernized under one model.

Here’s an update on the FASB’s project to revamp the rules for recognizing, measuring, presenting and disclosing software costs. The project is based on feedback from companies that find the current rules complex and costly.

Applying the existing guidance

There are two main areas of U.S. Generally Accepted Accounting Principles (GAAP) that provide accounting guidance for software costs. To determine how to account for software costs, a company first must evaluate which area of GAAP applies. The guidance that a company must follow is largely dependent on how a company plans to use the software.

Specifically, when a company determines that it has a substantive plan to sell, lease or otherwise market software externally (including licensing), it’s required to account for the software costs as external use. In this situation, Accounting Standards Codification Subtopic 985-20, Software — Costs of Software to Be Sold, Leased, or Marketed, would be applied.

Conversely, if a company doesn’t have such a substantive plan in place when software is under development, it’s required to account for the software costs incurred to develop or purchase software as internal use. In this situation Subtopic 350-40, Intangibles — Goodwill and Other — Internal-Use Software, would be applied.

The guidance for internal-use software is generally applied to hosting arrangements by both the vendor that’s incurring costs to develop the hosting arrangement for customers (such as software-as-a-service) and the customer incurring costs to implement the hosting arrangement. However, Subtopic 985-20 applies to hosting arrangements in which 1) a customer has a contractual right to take possession of the software at any time during the hosting period without significant penalty, and 2) it’s 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.

Designing a one-size-fits-all approach

The ultimate goal of the FASB’s project on reporting software is to align the differing accounting models for external and internal use. If the project takes shape as planned, companies will no longer have to distinguish between two sets of guidance. Instead, they’ll apply a single model for all software. That means everyone would follow the same model, regardless of whether they purchased software as a license, entered into a cloud computing arrangement, or developed internal software, licenses or cloud solutions.

However, there’s little consensus now on how that model would work. Approaches currently being researched by FASB staff include:

  • Requiring software costs to be capitalized based on a principle such as when there’s a present right to the economic benefit as a result of incurring the software costs,
  • Requiring software costs to be capitalized if they’re undertaken during certain development activities, and
  • Expensing all software costs, including cloud computing.

Members of the Private Company Council gave mixed views on which approach they favored, reflecting the difficulty the FASB could ultimately face on the topic. Some financial statement preparers prefer a principles-based approach, while others said they like the idea of expensing software costs as there’s no true prediction of its future useful life.

Stay tuned

This project is currently in the deliberation phase. No proposals have yet been issued, but the FASB plans to discuss this topic in the coming months.

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