Warning: Your Assets May Vanish in the Cloud!
In today’s technologically-driven environment, the popularity of internet-based cloud software (for a wide variety of uses) continues to climb. Subscription software licensing and delivery models, which garner access to critical applications via the internet, have transformed the foundation of how we conduct business. Sometimes referred to as “Software as a Service” (abbreviated as SaaS), this sales delivery model has mobilized the form and function of business interactions worldwide and has eliminated many of the physical barriers to working arrangements that once limited us – such as access to computers and hardware preloaded with software licenses. Sometimes also referred to as “on-demand software“, common SaaS examples that we all have likely heard of include Salesforce, Workday, Concur, Citrix GoToMeeting, and Cisco WebEx, to name just a few.
With all of the benefits that come along with these type of arrangements, it’s no surprise that the potential impact on a company’s balance sheet, tax planning, financial forecasts, and capital budgeting is often overlooked during the decision process. That’s because SaaS contracts do not qualify as bona fide software license purchases under U.S. GAAP. Unlike traditional software purchases, cloud-based software typically does not provide the customer with “ownership rights” inherent to the accounting definition of an “asset,” which thereby eliminates common capitalization treatment for software purchases. While most managers have grown accustomed to budgeting software as a capital or intangible asset purchases, now your software contract may be treated as a service contract with periodic payments expensed as incurred rather than capitalized and depreciated or amortized. This accounting change, if not appropriately considered, could leave you with higher administrative expenses and unused portions of capital budgeted resources. With all of that being said, it’s important to give this due consideration as this may significantly impact your company’s budget and decision making processes down the road.
In 2015, the Financial Accounting Standards Board (FASB) issued Accounting Standard Update (ASU) Number 2015-05, Customers Accounting Fees Paid in a Cloud Computing Arrangement. This update was provided to clarify cloud-based software computing arrangements under U.S. GAAP and effectively eliminated the requirement for acquired software licenses to be accounted for under lease guidance. The accounting standard was effective for public companies in fiscal years starting after December 15, 2015 and private companies one year later in fiscal years starting after December 15, 2016. When conditions under ASU 2015-05 are met, cloud-based software arrangements qualify as internal-use software under ASC 350-40, which requires the same accounting treatment as intangible assets. However, many SaaS contracts will not meet the internal-use software definition when a hosting arrangement does not include a software license by FASB definition. FASB defines a “hosting arrangement” in this ASU as follows: Hosting Arrangement – In connection with the licensing of software products, an arrangement in which an end user of the software does not take possession of the software; rather, the software application resides on the vendor’s or third party’s hardware, and the customer accesses and uses the software on an as-needed basis over the Internet or via a dedicated line.
A few simple questions will help to determine if your cloud-based software contract contains a software license. Keep in mind, both questions must be answered “yes” for a SaaS agreement to contain a software license and qualify for intangible asset treatment under US GAAP ASC 350-40:
- The customer has the contractual right to take possession of the software at any time during the hosting period without significant penalty.
- It is feasible for the customer to either run the software on its own hardware or contract with another party unrelated to the vendor to host the software.
If you answered no to any of the questions above, your cloud-based arrangement does not qualify, and must be treated as a service agreement where all payments are expensed as incurred. That asset you may have been planning to recognize will essentially “vanish” from the balance sheet and directly impact the bottom line as an additional administrative expense.
In March 2018, FASB’s Emerging Issues Task Force (EITF) issued a proposed ASU exclusively for cloud-based software arrangements that qualify as service contracts in order to address accounting treatment for implementation costs associated with such arrangements. Many cloud-based software solutions still require significant up-front implementation costs and customization that will certainly draw attention and consume budgeted resources.
The ASU proposes that companies capitalize implementation costs and certain enhancements over the contract period as part of their service contracts. Under the proposal, these deferred implementation costs would be expensed over the term of the hosting agreement, which would include the non-cancelable term plus any reasonably certain renewal terms in the contract. This guidance would provide clarity for better financial planning and budgeting as it relates to software contracts and capital expenditures. The ASU proposal has received supportive comments from companies such as Alphabet (Google), IBM, Apple, Ford Motor Company and Salesforce.com. A final decision is currently pending approval.
Should you need assistance with reviewing, planning or interpreting your cloud-based software contract arrangements, please contact PKM and we’ll gladly provide you with assistance and more advice as the guidance changes.