Sometimes a simple answer to an accounting problem does not necessarily produce simple accounting. That’s apparently the case with new guidance from the Financial Accounting Standards Board on how to account for certain cloud computing costs.
FASB issued Accounting Standards Update No. 2018-15 to explain how companies should account for costs associated with implementing a cloud computing arrangement when it is regarded as a service contract. To some extent, it resolves a conundrum companies began encountering after the board issued ASU No. 2015-05 on accounting for cloud computing costs, which was meant to sort out how to treat access to software that would be gained via a cloud arrangement.
Accounting associated with software is a classic pain point in U.S. Generally Accepted Accounting Principles, or GAAP. As an intangible asset that is bought and sold under licensing arrangements, the accounting is not nearly as straightforward as it is to account for the purchase of equipment or real estate.
If it weren’t already difficult enough to account for software meant for use on a company’s own hardware, the provision of software under cloud computing arrangements only added a new layer of complexity.
It is important, however, to sort out how to account for the various costs associated with cloud arrangements because it means the difference between capitalizing or expensing costs. Capitalized costs produce assets on the balance sheet and an amortization or depreciation schedule to reduce their value over time. Expensed costs reduce revenue, removing profit from the income statement all in one reporting period.
Given the migration of corporate computing activity to the cloud, implementation costs associated with cloud arrangements can command big investment dollars. “Imagine the difference of expensing potentially millions in costs over, for example, a three- to six-month period of implementation compared with recognizing them over a longer multiyear subscription period,” says Scott Muir, an audit partner at KPMG. “There can be a significant difference.”
FASB’s 2015 guidance on accounting for cloud computing costs sought to help companies sort out whether a cloud computing arrangement contained a software license. That would affect whether a company would need to tease out the software element from the arrangement and account for it under the thicket of rules regarding acquisition of software.
Issued as part of FASB’s initiative to simplify accounting, the guidance essentially told companies they were only getting a software license under a cloud computing arrangement if they were getting software that they could separately download and operate on their own hardware, says Rahul Gupta, a partner in the national professional standards group of Grant Thornton.
“I wouldn’t say this makes it simpler. In reality, now there’s more guidance to navigate, but this is something users were asking for. The FASB fixed the model and gave users and preparers what they wanted, but ultimately it’s going to introduce complexity they didn’t have to deal with before.”
Chris Chiriatti, Managing Director, Accounting and Reporting Services, Deloitte & Touche.
“In most cloud computing arrangements, the cloud computing provider is not giving you a software license as defined by the FASB,” says Gupta. That meant very few cloud computing arrangements would be accounted for as anything other than service contracts. “Everyone knew what to do,” he says.
That seemed simple enough, at least at first.
As cloud computing exploded, preparers began to recognize that they were investing a lot of money into arrangements where they felt like there should be some greater opportunity to capitalize rather than directly expense costs. “Unfortunately, you have to expense everything,” says Gupta. “There’s a mismatch of when the benefits accrue and when the expense must be recognized. That gave preparers a lot of heartburn.”
Paradoxically enough, it was the adoption of cloud computing for accounting purposes that led to the biggest source of heartburn. As public companies have turned to cloud solutions to help them comply with a pending major change to lease accounting standards, the discomfort with the state of the accounting guidance on cloud computing grew, says Sheri Wyatt, a partner at PwC.
“The intersection of these pieces of guidance drives up the cost of implementing a lease accounting solution,” says Wyatt. “When you think of the software solutions a lot of companies are using to implement the leasing standard, many of them are cloud based.”
FASB responded to the call for reconsideration of its 2015 guidance and issued its newest guidance to effectively put the complexity of software cost accounting back into cloud computing accounting. The Board’s Emerging Issues Task Force studied the issues and recommended the change to accounting rules.
“This almost nullified what the FASB issued in 2015,” says Chris Chiriatti, managing director in accounting and reporting services in the national office at Deloitte & Touche. “It tells companies if you’re buying a software license or just software as a service, look at the costs exactly the same as far as what is eligible for capitalizing. It takes old guidance that’s been out there for 20 years and applies that framework to determine which costs should be capitalized.”
Under that guidance, companies need to keep careful track of implementation costs because some of those costs are eligible for capitalization and some are not, says Gupta. Generally, costs associated with the preliminary activity to implement a software license, or now a cloud solution that contains software, cannot be capitalized. That might include, for example, training costs or data conversion activity.
Costs associated with application development and implementation, however, can be capitalized. Post-implementation costs are treated liked preliminary costs, so they must be expensed as incurred as well.
That puts the onus on companies to have good processes and controls around identifying in which phase a particular activity falls so the cost can be properly reflected, says Gupta. “Sometimes the phases intermingle with each other,” he says, so tracking those phases and costs will be critical to accurate accounting.
“I wouldn’t say this makes it simpler,” says Chiriatti. “In reality, now there’s more guidance to navigate, but this is something users were asking for. The FASB fixed the model and gave users and preparers what they wanted, but ultimately it’s going to introduce complexity they didn’t have to deal with before.”
The new guidance takes effect for public companies in 2020, but early adoption is permitted. Companies can also decide if they will adopt prospectively, meaning going forward, or retrospectively, which means recasting prior periods presented in a set of financial statements. “Our expectation is that a large number of companies will early adopt,” says Muir. “It was the companies entering into these cloud computing arrangements that were really asking for this change.