Companies preparing to apply new guidance on how to account for cloud computing fees are finding that guidance is not necessarily simpler, and doesn’t always give them a sunny outcome on the financial statement, either.
The Financial Accounting Standards Board approved Accounting Standards Update No. 2015-05 in April 2015 to end some uncertainty among corporate accounting departments about how to report fees paid to enter into cloud computing arrangements. Accounting rules have long required detailed requirements for companies selling such arrangements when they involve some bundling of product and service, but companies have been left to their own ideas (until this latest guidance) on how to reflect cloud computing costs in financial statements.
Some companies have likened their cloud computing arrangements to leases (since they are leasing data storage on the Internet) and followed leasing guidance, treating the costs as expenses to be recognized in the income statement as they are incurred. Other companies have recognized their arrangements as the purchase of intellectual property, so they might put a related asset and liability on the balance sheet and amortize it over time.
FASB developed the new guidance as part of its simplification initiative, where the board is looking for ways to make Generally Accepted Accounting Principles easier to apply without making information any less available to investors. “As I look at this, it’s hard for me to find the simplification,” says Steve Hobbs, a managing director at consulting firm Protiviti. “If someone thinks this is going to reduce the cost of compliance and reduce complexity, I’d say this is more around clarification and consistency.”
The new guidance says companies must dig into their cloud computing arrangements and separately identify where they have gained rights to software and where they are only purchasing a service. Purchasing software is treated as the purchase of an asset, capitalized and amortized on the balance sheet. Purchasing service is treated like any other service agreement, where expenses are recognized as they are incurred, straight to the income statement.
“It will come down to what is in the contract,” Hobbs says. “It will likely require some bifurcation or allocation of value between licensing and services. If you’ve been treating this simply as an executory contract like a lease, now you’re going to have to go through some bifurcations.”
“As I look at this, it’s hard for me to find the simplification. If someone thinks this is going to reduce the cost of compliance and reduce complexity, I’d say this is more around clarification and consistency.”
Steve Hobbs, Managing Director, Protiviti
That’s going to require some judgment, says Rich Stuart, a partner at audit firm RSM U.S. (formerly known as McGladrey). The guidance provides some specific criteria for companies to apply to determine whether they have purchased software. “In determining if you have a software license, you have to determine whether you have a contractual right to the software—whether you are taking possession of the software without incurring a significant penalty,” he says. “That penalty could be monetary, or it could be something else, maybe the cost of hiring someone to run it. So there’s judgment in whether you might incur a significant penalty.”
Research firm Global Industry Analysts projects the market for cloud computing in the United States will reach nearly $130 billion in 2017. Cloud computing is becoming an increasingly common way for business to manage a wide variety of business information, says Joe Talley, a partner with Deloitte & Touche. “For most companies, it may not be material, but it certainly will be for others,” he says. “This is not trivial.”
Talley says he hears increasingly frequent questions about how to apply the new guidance, especially about recognizing the upfront costs companies often incur to establish cloud computing arrangements. If the contract is to be treated as a service arrangement, that represents a huge upfront cost to expense immediately, even when the company will enjoy a longer-term future benefit arising from that cost, he says.
Below is an excerpt from PwC describing the provisions of FASB's new cloud computing accounting standard.
1. Under the new standard, fees paid by a customer in a CCA will be within the scope of the internal-use software guidance if both of the following criteria are met:
The customer has the contractual right to take possession of the software at any time during the CCA period without significant penalty.
It is feasible for the customer to run the software on its own hardware (or to contract with another party to host the software).
2. The standard provides some guidance on how to interpret the term “significant penalty.” The ability to take delivery of the underlying software without significant cost and to use that software separately without a significant reduction in value would indicate there is not a significant penalty. Determining whether taking possession of the software will result in significant penalty will require judgment.
3. Arrangements that do not meet both of the criteria are considered service contracts, and separate accounting for a license will not be permitted. Arrangements that meet the criteria are considered multiple-element arrangements to purchase both a software license and a service of hosting the software. Existing guidance on internal-use software is applied to the purchased license.
4. Costs incurred by a customer in a CCA that includes a software license should be allocated between the license and hosting elements. The consideration should be allocated based on the relative fair value of each element. Determining the fair value of the software license and hosting service may require the use of estimates. Management should consider all relevant information, such as information from the negotiation process with the vendor, in estimating the fair value of the license. More observable inputs might be available to estimate the fair value of the hosting element.
“Those upfront costs can be substantial,” Talley says. From the customer’s perspective, he continues, preparers might follow this thinking: “I wouldn’t be incurring this cost if not for expecting a benefit over some future time, so would it not make sense to defer that cost and spread it over the time that I’m going to benefit from this arrangement? I can see that logic, but you have to look to the structure of the arrangement.”
Companies that have traditionally capitalized and amortized their cloud computing expenses might now find they have to expense them; that will affect their income statement metrics, says Mike Coleman, a partner with PwC. That could include the popular non-GAAP metric known as EBITDA (earnings before interest, taxes, depreciation, and amortization), which many companies and investors use as a way of assessing operating efficiency.
“If you’re a company where EBITDA is important, and now the cloud computing cost is an operating expense, now the EBITDA metric is different,” he says. “Companies are getting their heads around: Am I reading that right? What do I do with that implementation fee if I’m not buying software?”
Some say the new accounting could lead to discussions between providers and customers about renegotiating cloud computing contracts. Perhaps customers will ask for more rights to the software so they can continue capitalizing and amortizing; perhaps they will ask for relief on upfront implementation costs so they can spread those expenses out over the life of the contract.
Peter Bible, a partner and chief risk officer at audit firm EisnerAmper, doesn’t expect a seismic shift. “We might see contracts written a little differently to make it clear when you are getting a license,” he says. “The market will adjust to it. The suppliers of cloud computing and their customers will adjust.”
The new guidance takes effect for calendar year companies in 2016, but companies will need to make some adoption decisions by the end of this year, says Brad Hale, a member of the professional standards group at audit firm Mayer Hoffman McCann. Companies will need to disclose if they plan to adopt the standard retrospectively, reflecting it in prior periods as if it had always been in place; or prospectively, only for new periods going forward.
“There are disclosure requirements for each, but the disclosure requirements are more arduous under the prospective treatment,” he says.