The benefits of cloud computing are considerable, and recent accounting changes have made cloud solutions even more attractive to many businesses. On August 29, 2018, the FASB issued new guidance on a customer's accounting for implementation, set-up and other upfront costs incurred in a cloud computing arrangement (CCA) hosted by the vendor—that is, a service contract. Under the new guidance, a customer will apply the same criteria for capitalizing implementation costs of a CCA as it would for an on-premises software license. Moving data, applications and platforms to the cloud may create substantial business benefits because companies may be able to reduce capital expense outlays while maintaining a more flexible IT environment. However, companies should consider the financial reporting implications as well as broader tax and IT considerations as a result of the new accounting guidance.
Playback of this video is not currently availableVideo: Moving IT solutions to the cloud? Consider the financial reporting as well as the broader tax and IT considerations resulting from the new cloud computing guidance.
| Traditional IT | Cloud | |
|---|---|---|
| Capital outlays for hardware & applications | Yes | No |
| Flexible IT infrastructure | No | Yes |
| Built-in scalability | No | Yes |
| Customer’s costs categorization | Capital–No impact to EBITDA [1] | Operating–Reduces EBITDA |
[1] Earnings before interest, tax, depreciation, and amortization
Here’s a quick comparison of what has changed, comparing the previous standard to the new guidance:
[2] Accounting Standards Update (ASU) 2015-05, Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement
If the CCA includes a software license, under the old guidance, the license is within the scope of the internal-use software guidance. This addresses which costs should be capitalized, including the cost to acquire the license and the related implementation costs.
If the CCA does not include a software license, the arrangement is a service contract, and the fees for the CCA are recorded in the same way as other SaaS expenses, generally as operating expense. The previous guidance does not specifically address the accounting for implementation costs related to a service contract.
The new guidance clarifies that implementation costs, including CCAs that do not transfer a software license, may qualify for capitalization based on the phase and nature of the costs.
| Potentially capitalizable | Generally not capitalizable |
|---|---|
| External direct costs of materials | Costs for data conversion activities |
| Third-party service fees to develop the software | Costs for training activities |
| Costs to obtain software from third-parties | Software maintenance costs |
| Coding and testing fees directly related to software product |
Key challenges in accounting for software investments stem from the changes in software development practices. Previously, a linear or “waterfall” method typically involved a sequential software design process that “flowed” steadily downwards through lengthy development phases. Accounting for investments in linear/waterfall development methods was relatively straightforward, compared to today’s environment.
Current technology and software development processes now largely follow an agile development life cycle. With agile software development, requirements and solutions—including many involving CCA arrangements—evolve through collaboration among self-organizing, cross-functional teams. These methods have many advantages.
However, reconciling agile development and delivery models with outdated financial reporting rules creates complexities:
Determining which operational aspects of CCA software implementation activities are eligible for capitalization requires judgment and an analysis of the nature of the costs incurred. As discussed earlier, this can be particularly challenging in an agile environment. Here are some of the operational challenges that could influence whether implementation activities are eligible for capitalization, which must be addressed.
To assist in addressing these challenges, companies can use this as an opportunity to leverage technology through process automation. Visualization tools can be used to simplify and track the end-to-end process of CCA for data already captured today, or tracked specifically for project purposes. By leveraging existing technology and embracing process automation, business decisions can be made quicker, with real-time information, leading to more efficient processes and comprehensive outcomes related to accounting treatments and technology solutions.
Additionally, a cloud computing contract may require application of multiple accounting standards—many of which have also recently changed. In these situations, companies need to consider whether costs, which would otherwise have been within the scope of the updated cloud computing standard, are accounted for using a different standard. For example, if a CCA includes an explicit or embedded lease (e.g. dedicated equipment/servers), the company would need to determine which costs are accounted for under ASC 842, versus the new cloud computing standard.
