A company is developing new software solely for its own internal use in payroll processing. In the first two months, its team evaluates alternative technologies and determines performance and system requirements, and no decision to proceed has yet been approved by management. In months three through eight, management authorizes funding and commits to completing the project, and the team performs coding, installation, and testing before the software goes live in month nine. Under the cost capitalization framework in ASC 350-40 (as in effect before ASU 2025-06's later removal of the stage-based model, effective for fiscal years beginning after December 15, 2027), how should the costs incurred in the first two months and in months three through eight, respectively, be treated?
- Costs in the first two months (the preliminary project stage) are expensed as incurred; costs in months three through eight (the application development stage) are capitalized
- Costs in both stages are capitalized, because all costs incurred on a specifically identified internal-use software project are capitalizable once the project has begun
- Costs in the first two months are capitalized as preliminary feasibility costs, while costs in months three through eight are expensed as ordinary maintenance
- Costs in both stages are expensed as incurred, because internal-use software costs are capitalized only once the software is placed into service in month nine
Why A? And why not the others?
Correct answer: A. Costs in the first two months (the preliminary project stage) are expensed as incurred; costs in months three through eight (the application development stage) are capitalized
ASC 350-40 (in its stage-based form, still the effective model as of the 2026-27 fiscal years, before ASU 2025-06 removes it for fiscal years beginning after December 15, 2027) divides internal-use software development into stages with different cost treatments. During the preliminary project stage — evaluating alternatives and determining performance and system requirements, with no management commitment yet — activities resemble research and development, so all costs are expensed as incurred. Once management with appropriate authority authorizes and commits to funding the project, the entity enters the application development stage, and internal and external direct costs of coding, installation, and testing incurred from that point are capitalized. Here the first two months fall squarely in the preliminary stage (expensed) and months three through eight fall in the application development stage (capitalized). The option capitalizing both stages ignores the preliminary stage's R&D-like treatment. The option reversing the two stages' treatment — capitalizing preliminary costs and expensing application development costs as 'maintenance' — inverts the rule entirely. The option expensing everything until go-live ignores that capitalization begins with management's authorization and commitment during the application development stage, not at the software's in-service date.
Source: FASB ASC 350-40-25 (costs of software developed or obtained for internal use — preliminary project stage and application development stage), noting ASU 2025-06's later removal of this stage-based model