Understanding ASU 2025-06: What Entities Need to Know About Accounting for Internal-Use Software

The existing accounting guidance in Subtopic 350-40, Intangibles – Goodwill and Other – Internal-Use Software was developed when software development followed a largely prescriptive approach in which the development progressed through defined stages. Software development methods have since evolved to take more incremental and iterative approaches, which can make it difficult to determine when to start capitalizing internal-use software costs.

To address this challenge, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU or Update) 2025-06, Targeted Improvements to the Accounting for Internal-Use Software to modernize the accounting for internal-use software and align the guidance with the methods currently used to develop the software.

Applicability

The amendments in this Update are applicable to all entities subject to guidance on internal-use software as well as entities that account for website development costs in accordance with Subtopic 350-50, Intangibles – Goodwill and Other – Website Development Costs.

Note: This Update does not affect software costs accounted for under Subtopic 985-20, Software – Costs of Software to be Sold, Leased, or Marketed.

Main Provisions of ASU 2025-06

The amendments in this Update remove all references to “project stages” from Subtopic 350-40 and require an entity to begin capitalizing software costs when both of the following occur:

• Management authorizes and commits to funding the software project.
• It is probable the software project will be completed and the software will be used to perform the function intended (referred to as the “probable-to-complete recognition threshold”).

Common examples of the authorization and funding commitment include management’s approval of funding for the internal development of an application, the execution of a contract with a third party to develop software, or the execution of a contract to obtain software from a third party. The term “probable” in the second condition above is defined in the Master Glossary as “the future event or events are likely to occur.”

The probable-to-complete recognition threshold requires an entity to assess whether there is significant uncertainty associated with the development activities of the software (referred to as “significant development uncertainty”). Significant development uncertainty exists if either of the following factors are present, as detailed in ASC 350-40-25-12A:

• The software being developed has technological innovations or novel, unique, or unproven functions or features, and the uncertainty related to those technological innovations, functions, or features, if identified, has not been resolved through coding and testing.
• The significant performance requirements of the software have not been identified, or the identified significant performance requirements continue to be substantially revised. The term “performance requirements” was added to the Master Glossary by this Update and is defined as “what the entity needs the software to do (for example, functions or features).”

When significant development uncertainty exists, the probable-to-complete recognition threshold is not met and capitalizing software costs of a project would not yet be appropriate. Once an entity resolves the matter(s) causing significant development uncertainty, it should begin capitalizing software costs if all other capitalization requirements are met.

Note: The amendments in this Update do not change what costs should be capitalized as part of a software project or when capitalization should cease (when a software project is substantially complete and ready for its intended use).

The following examples, adapted from the illustrations included in ASU 2025-06, demonstrate the application of the amendments in this Update.

Example 1 – Implementation & Customization of an ERP System

On January 1, 20X2, Service Co. begins internal discussions about implementing an ERP system across the entity. Research and due diligence procedures commence shortly thereafter and on May 1, 20X2, management executes a contract with a third party to implement a commercially developed solution that includes both on-premises software and cloud services. As part of the contract with the third party, Service Co. will select certain customizations from existing functionality and features available for the software. Based on the experience of the third party being used, management concludes it is probable that the software project will be completed and function as intended.

Analysis

(1) When has management authorized and committed to funding the software project?

Management authorized and committed to funding the software project on May 1, 20X2, when it executed the contract with the third party.

(2) Does this software project meet the probable-to-complete recognition threshold?

Yes. Management determined it is probable that the project will be completed and significant development uncertainty does not exist because the company is purchasing a developed solution that does not have novel, unique, or unproven technological innovations and the only customizations to be made are from existing functionality and features of the software.

Service Co. concludes the capitalization requirements are met on May 1, 20X2 and begins capitalizing eligible software costs on that date — including those costs related to implementation and customization of the on-premises software and those related to implementation of the cloud services features.

Example 2 – Development of a Mobile Application

Connect Co. is developing a new mobile application, Z-App. Management approves funding to internally develop Z-App on March 1, 20X2. However, the company has not yet identified what functions and features will be included in the application. Connect Co. continues to develop the functions and features of Z-App and modify the development to incorporate feedback from preliminary user groups. On November 1, 20X2, management concludes it has identified the significant functions and features Z-App needs (and does not expect substantial changes to those requirements). During the application development process, management determined that Z-App does not have technological innovations or novel, unique or unproven functions or features.

Analysis

(1) Does this project meet the requirements for software cost capitalization as of March 1, 20X2?

No. Funding for the internal development of Z-App is approved; however, significant development uncertainty exists because the software’s performance requirements have not been identified.

(2) Does this project meet the requirements for software cost capitalization as of November 1, 20X2?

Yes. Because management has identified the software’s significant performance requirements and does not expect those requirements to be substantially revised, the significant development uncertainty has been resolved as of November 1, 20X2. As a result, Connect Co. concludes the capitalization requirements are met on November 1, 20X2 and begins capitalizing eligible software costs on that date.

Example 3 – Development of a Novel Technology

Tech Co. begins internal discussions about developing software with novel functionality on June 1, 20X1. On July 1, 20X1, management of Tech Co. approves a budget for the internal development of the software and assigns an internal team to begin developing the software, which still has novel functionality. On April 1, 20X3, Tech Co.’s internal development team resolves the novel functionality uncertainty through coding and testing and determines it is probable that the software will be completed and perform the intended function. Additionally, on April 1, 20X3 management determines it does not expect substantial revisions to the significant performance requirements in the software. On May 1, 20X3, Tech Co. completes substantially all testing and determines the software project is ready for its intended use.

Analysis

(1) At what date does this project meet the requirements for software cost capitalization?

April 1, 20X3. Management committed funding to the project on July 1, 20X1 by approving a budget and allocating the internal development team; however, significant development uncertainty existed as of that date because significant performance requirements had not yet been identified and the novel functionality of the software being developed had not been resolved through coding and testing. Significant development uncertainty remained until April 1, 20X3, when the novel functionality was resolved and the significant performance requirements were identified (and not expected to substantially change).

(2) For what period should eligible software costs be capitalized?

All eligible software costs should be capitalized beginning April 1, 20X3. Tech Co. should cease capitalizing eligible software costs on May 1, 20X3, the point at which the project is substantially complete and ready for its intended use.

Additional Considerations

Unit of Account

An entity is obligated to apply the capitalization requirements in Subtopic 350-40 to a software project (the unit of account); however, the term “software project” is not defined in the guidance. The FASB chose not to address the unit of account in this Update because it could “change practice or limit judgment that is currently allowed,” as described in the Background Information and Basis for Conclusions in ASU 2025-06. Instead, the FASB indicated that an entity should use its judgment in determining what represents a software project within the context of Subtopic 350-40.

Disclosure

The amendments in this Update specify that the disclosure requirements of Subtopic 360-10, Property, Plant and Equipment – Overall, apply to all capitalized software costs accounted for under Subtopic 350-40, regardless of how those costs are presented in the financial statements. This means that an entity must disclose capitalized internal-use software costs and accumulated amortization at the balance sheet date as well as the amortization of internal-use software costs for the period and a description of the amortization method used.

Additionally, this Update clarifies that disclosure requirements in ASC 350-30-50-1 through 50-3 related to intangible assets are not required for software costs accounted for under Subtopic 350-40.

Website Development Costs

The amendments in ASU 2025-06 supersede the existing guidance in Subtopic 350-50, Intangibles – Goodwill and Other – Website Development Costs and incorporate the website-specific development cost recognition requirements into Subtopic 350-40.

Note: In the Background Information and Basis for Conclusions in ASU 2025-06, the FASB stated “capitalization of internal-use software costs generally will not change significantly for most types of software under the amendments in this Update. For the development of software to be provided via a cloud computing arrangement (CCA), the Board expects that the amendments could result in a decrease in software capitalization.” However, applying the new guidance may require an entity to use more judgment than the current guidance when determining whether to capitalize costs or when to begin capitalizing costs given the facts and circumstances of a particular software project.

Effective Date & Transition

The amendments in ASU 2025-06 are effective for annual periods beginning after December 15, 2027, and interim periods within those annual periods. Early adoption is permitted as of the beginning of an annual reporting period.

Entities may apply the amendments in this Update using any of the following approaches:

• Prospective – Apply to new software costs incurred as of the beginning of the period of adoption for all projects, including in-process projects
• Modified – Apply prospectively to new software costs incurred (for all projects, including costs incurred for in-process projects) except for projects in-process at the date of adoption that do not meet the capitalization requirements under the new guidance but do meet the requirements under current guidance. For projects in-process that do not meet the capitalization requirements under the new guidance, derecognize any capitalized costs through a cumulative-effect adjustment to the opening balance of retained earnings as of the date of adoption.
• Retrospective – Recast comparative periods and recognize a cumulative-effect adjustment to the opening balance of retained earnings as of the beginning of the first period presented.

Next Steps for ASU 2025-06

The changes in ASU 2025-06 affect all types of entities. It’s important to have a trusted advisor on your side to help you navigate the complexity of accounting changes. Eide Bailly’s team of audit and assurance professionals can help you adapt to new standards as they arise, so you can streamline financial processes, reduce the risk of errors, and make informed decisions.