Introduction
For equipment finance professionals, it’s useful to understand changes to accounting standards. In September 2025, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update 2025-06 ‘Targeted Improvements to the Accounting for Internal-Use Software’ (ASU 2025-06, or the Update). ASU 2025-06 modernizes the accounting for software costs under Accounting Standards Codification (ASC) 350-40 Intangibles – Goodwill and Other – Internal-Use Software. The Update also applies to entities that account for website development costs under ASC 350-50, but does not affect software costs subject to ASC 985-20 Software – Costs of Software to Be Sold, Leased, or Marketed (external-use software).
Consistent with other accounting standards amendments, ASU 2025-06 began years earlier based on feedback from stakeholders. In December 2020, the FASB chairman announced the FASB was going to commence an agenda consultation process in 2021 to help decide where to focus standard-setting efforts going forward. Given the pace of technological change and software development, it is not surprising that the accounting for software development costs was determined to be a focus area.
In the equipment finance industry, software costs that are included in financing offerings are typically comprised of external-use software that is being marketed by a vendor; however, a lessee or obligor that is financing a software purchase that will be used internally or developing software will need to evaluate changes to their accounting for those costs and may have implications on the financial position of the entity, their lease vs. purchase decisions, and financial ratios and debt covenants.
Let’s start with a brief discussion of the methods of software development and the processes followed when entities are developing internal-use software, including a leasing software solution or enterprise resource planning (ERP). What do two of the common software development methods, Agile and Waterfall, really mean?
Waterfall is a linear and sequential approach to software development. Projects are managed in distinct phases (i.e., requirements, design, implementation, testing, deployment, and on-going support and maintenance). A key characteristic for this method is that each phase is generally completed prior to commencing the next phase. The current accounting guidance for internal-use software is generally predicated on this approach to software development.
Agile, on the other hand, is nonlinear. It is an iterative and flexible approach focused on deploying software in smaller cycles that are commonly referred to as “sprints.” This approach focuses on collaboration, feedback, and adaptability, which allows teams to quickly pivot to changing requirements. Similar to “Lean” principles, Agile promotes continuous improvement and working software over comprehensive documentation, making it ideal for projects where requirements evolve and stakeholder engagement is high.
What is Changing and Why?
Now that we’ve established the background on different software development approaches, let’s move on to a summary of what is changing and why:
What? ASU 2025-06 removes all references to prescriptive and sequential software development stages in order to clarify how the guidance applies to both linear and nonlinear software development. Upon the effective date of this Update, only the following two criteria must be met for entities to begin capitalizing software costs:
- Management, with the relevant authority, implicitly or explicitly authorizes and commits to funding a computer software project.
- It is probable that that the project will be completed and the software will be used to perform the function intended (referred to as the ‘probable-to-complete recognition threshold’).
This Update does also provide guidance on how to determine whether the ‘probable-to-complete recognition threshold’ has been met. ASC 350-40-25-12A(a) and (b) describe two factors that may indicate that there is significant development uncertainty.
- 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.
Why? Simply put, the objective was to foster better alignment with how software is developed.
- The feedback received consistently indicated to the FASB that the current guidance for internal-use software costs was outdated and no longer as relevant based on how software development has evolved. As you could surmise from reading the definitions of Waterfall and Agile, entities are shifting from the more rigid, sequential approach to more incremental and iterative development models. The result of a misalignment between accounting literature and guidance and the reality of how software is being developed and deployed is that entities are experiencing challenges when it comes to when to begin capitalizing internal-use software costs.
How does the Update differ from current generally accepted accounting principles (GAAP) and why is the Update an improvement?
The primary difference, and improvement, is the de-emphasis of project stages when it comes to determining whether and when costs are capitalized by removal of all references to software development project stages. Thus, the updated guidance is going to enable stakeholders to focus on the two criteria required to begin capitalizing costs and the expanded guidance on how to think about the ‘probable-to-complete recognition threshold.’ In addition, ASU 2025-06 serves the important purpose of helping decouple the accounting guidance from a specific software method (i.e., how current GAAP is geared toward Waterfall) and now it will be more apt to accommodate software development methods that may be used in the future.
To wrap up, the amendments to ASC 350-40 accounting standards update become effective for all entities for annual reporting periods beginning after December 15, 2027, and interim reporting periods within those annual reporting periods. Early adoption is permitted as of the beginning of an annual reporting period and multiple transition approaches are permitted. As with all changes to US GAAP, it’s always a great idea to get ahead of how it may impact your organization from a systems and process perspective.
