Software development cost accounting for SaaS, cloud, and on-premise solutions

By Sandie Kim, Senior Consultation Partner, National Office for Accounting and Reporting Services, and US Audit & Assurance Technology Industry Professional Practice Director (IPPD), Deloitte & Touche LLP

Talking points

• Which accounting guidance should you use—ASC 985-20 or ASC 350-40—to capitalize software development costs for SaaS, cloud, and on-premise solutions?
• The rise of generative AI software raises new questions about software development cost accounting for SaaS, cloud, and on-premise solutions.
• Deloitte can help you navigate continuous changes in the fast-moving technology, media, and telecommunications industries.

Artificial intelligence (AI) software has finally entered the mainstream. Generative AI tools, which use machine learning algorithms and input training, have matured to the point where they can now create text, images, videos, and computer code at a level approaching humans. Not surprisingly, the number of tech companies using AI software in their products is on the rise.

Like SaaS, cloud solutions, and other software advances, AI tools have development costs that must be accounted for correctly. In light of continuous software innovation, it is essential to keep pace with the relevant software cost accounting guidance and understand which of two applicable accounting standards—ASC 985-20 or ASC 350-40—applies in each situation. Determining which rule to use is a critical first step because the requirements for capitalization vary significantly between the two standards.

ASC 985-20, known as the software capitalization rule for external-use software, applies to software that an entity—typically a developer—intends to sell, lease, or market externally. “Externally,” in this case, means the software is used on-premise or “on-prem” by the customer.

ASC 350-40, on the other hand, governs software that an entity does not intend to sell, lease, or market externally, but rather will use internally. This standard is commonly referred to as the software capitalization rule for internal-use software because the entity develops software for its own internal use, sells subscriptions to software accessed by customers via the cloud or as SaaS, or purchases a cloud-based or SaaS hosting arrangement.

Understanding the differences

A key difference between ASC 985-20 and 350-40 is whether the customer can take possession of the software. With ASC 985-20, the software runs on the customer’s on-premise infrastructure (or the customer’s cloud vendor’s infrastructure). With ASC 350-40, it runs on the entity’s own internal infrastructure (or the entity’s cloud vendor’s infrastructure) where it can be accessed online by subscribing customers as SaaS or cloud solutions or used internally by the entity.

Another key difference is that ASC 985-20 requires the establishment of technological feasibility before software costs can be capitalized. Because technological feasibility is often established shortly before the software product reaches the GA stage, many entities do not have material costs capitalized under ASC 985-20.

Conversely, ASC 350-40 does not require the establishment of technological feasibility for capitalization. Instead, it says that capitalization depends on the software solution’s stage of development. Generally, certain development costs incurred during the application development stage are capitalized, while costs incurred outside that stage are expensed.