A software company that capitalizes development payroll turns current expense into an asset. That raises earnings, covenant ratios and sale value, which is exactly why the balance gets attention in an audit. The accounting also changed: ASU 2025-06 replaces the project-stage model for internal-use software. This guide covers which standard applies, how each works and how to test the balance.
Which standard applies
Two Subtopics cover software costs, and scoping comes first.
- ASC 985-20 covers software to be sold, leased or marketed, as a separate product or as part of a product or process. The usual example is traditional software installed on a customer's server or computer.
- ASC 350-40 covers software used solely for the entity's internal needs or to serve customers, including SaaS hosting that customers access online.
For hosted software the dividing line is the hosting test in ASC 985-20-15. Two questions decide: can the customer take possession of the software during the hosting period without a significant penalty, and can the customer run it on its own hardware or through an unrelated third-party host? If both answers are yes, the costs fall under ASC 985-20. If either is no, the arrangement is a service and ASC 350-40 applies. Document the conclusion for each product line. Many clients have both.
ASC 985-20: software to be sold
Development costs are expensed as research and development until technological feasibility is reached. Feasibility is reached when planning, designing, coding and testing are complete enough to confirm the product meets its design specifications. The client shows it through a complete detailed program design or a working model, meaning operative software ready for customer testing. Agile teams rarely produce a detailed program design, so the working model is the usual milestone to evidence. After feasibility, costs are capitalized until the software is ready for general release, and later enhancements are capitalized.
Amortization begins when the products are released for sale. The carrying amount is then protected by a net realizable value test: when net realizable value is insufficient to recover the capitalized amount, an impairment is recorded.
ASC 350-40: internal-use software
Under the existing project-stage model, the preliminary stage is expensed, the application development stage is capitalized, and the post-implementation stage is expensed. Application development includes design of configuration and interfaces, coding, hardware installation and testing, with related payroll, overhead and third-party fees. Training, maintenance and bug fixes are expensed.
ASU 2025-06
The FASB issued ASU 2025-06 in September 2025. It removes references to project stages, so the rules work for traditional and agile projects alike. Capitalization begins when both conditions are met:
- Management with the relevant authority has authorized and committed to funding the project.
- It is probable the project will be completed and the software will perform its intended function.
Capitalization cannot begin while significant development uncertainty exists. That is the case if the software involves technological innovations or novel, unique or unproven features whose uncertainty has not been resolved through coding and testing, or if significant performance requirements are unidentified or keep being substantially revised. Software under ASC 985-20 is unaffected.
The effective date is annual periods beginning after December 15, 2027, and interim periods within them, with early adoption permitted. Entities choose among prospective, modified and retrospective transition. Crowe reports that the FASB expects more costs to be expensed for cloud-sold software. See the firm's ASU 2025-06 standards page and ASC 360 and ASC 350 impairment.
Risk areas
Payroll allocation. Most of the balance is employee time. If timesheets are estimated by managers at period end, the capitalized amount is whatever management wants.
Stage or threshold timing. Capitalization can start before the criteria are met, or continue into maintenance.
Maintenance versus enhancement. Costs that add functionality are upgrades and follow the development criteria. Costs that do not are maintenance and are expensed.
Impairment and abandonment. Shelved or pivoted projects can stay on the balance sheet.
Amortization start and life. Test the start date and useful life against release and go-live evidence.
Worked example
This is an illustrative example. A SaaS client that adopted ASU 2025-06 early capitalizes $1,800,000 of developer payroll for a new analytics module over the year. The audit tests find the following. Management confirms the project was funded in March, but engineers were still resolving whether an unproven forecasting model would work until June. Under the significant development uncertainty indicator, capitalization could not start until the uncertainty was resolved through coding and testing. The costs incurred before that point, $450,000, are expensed in the period incurred. In addition, $120,000 of time relates to bug fixes after launch in November and is maintenance. The adjusted balance is $1,800,000 less $450,000 less $120,000, or $1,230,000.
The effect: $570,000 moves from the asset to operating expense. If the client's loan covenant measures EBITDA with the amortization added back, the capitalized costs flatter the metric for years. That is why the lender and the owner care about this test.
Typical audit procedures
- Obtain the capitalization policy and the scoping memo for each product.
- Obtain the project list, with approval dates, funding authorization and the date management concluded completion was probable.
- Reconcile capitalized payroll to the payroll register. Test timesheets or time-tracking records for a sample of employees and confirm they support the project, not another task.
- Evaluate the significant development uncertainty analysis for projects with novel features or shifting requirements.
- Test the start and end dates of capitalization with dated evidence: sprint records, release notes, test results and go-live dates.
- Recompute amortization and confirm the start date and useful life.
- Evaluate impairment indicators: abandoned projects, lost customers and low usage. For ASC 985-20 products, test net realizable value against forecast revenue.
- Test the disclosures. See AU-C 540 for the estimate-testing approach.
PBC items
- Capitalization policy and ASC 350-40 or 985-20 scoping memo
- Project roster with budget, approval and completion dates
- Payroll register tied to capitalized payroll
- Timekeeping records by engineer and project
- Third-party contractor invoices and contracts
- Amortization schedule and useful life support
- Roadmap, forecasts and impairment analysis
Red flags
- Capitalization rate that rises in the year a covenant tightens
- Round-number allocations of payroll to projects
- Engineers on timesheets with no activity in the repository
- Costs capitalized before requirements were stable
- Projects with no completion date for several years
- Capitalized costs that continue after launch
Sources
- FASB ASU 2025-06, Intangibles, Goodwill and Other, Internal-Use Software (Subtopic 350-40), as summarized by RSM US and Crowe
- FASB ASC 985-20 and ASC 350-40, Software
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AU-C references are to AICPA Professional Standards, paraphrased here; read the standard itself before relying on a requirement. This page is guidance, not professional advice. Report an error