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The Accounting Rule You Need to Know Before Moving to the Cloud
On January 12, 2017 / By Adam Smith and Joseph Kasbaum

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Accountant at her desk. Making calculations based on new accounting rules.

There are a number of factors our clients consider when evaluating the purchase of cloud software.  The main factors for consideration often include: system performance, security, data access and of course, cost, specifically which costs must be expensed and which costs can be capitalized.

Due to the recent updates of standards for intangible asset accounting, the rules for which costs can be capitalized and expensed are no longer as clear-cut as they used to be. The presumption a company can capitalize costs incurred with software implementation activities no longer holds true under every circumstance, or type of contract, when it comes to cloud software.

At the beginning of 2016, the Financial Accounting Standards Board (FASB) threw an Adam Wainwright-style curve ball to companies which are evaluating or have purchased cloud computing software. You can read the full update to the Accounting Standards Codification (ASC) 350-40, Internal Use Software here.

However, the update created somewhat of a gray area around whether a cloud computing agreement represents a purchase of software or a purchase of services.

The update states depending upon the specific language of a cloud computing contract, the purchase costs may be viewed one of two ways:

  1. as the purchase of a software license
  2. as the purchase of a service

In order to be deemed as a purchase of a software license the cloud computing contract must explicitly denote the customer is paying for the transfer of a license required to operate the software.  Otherwise, the contract is viewed as a purchase of services.

If a contract is viewed as a purchase of services, then the costs must be accounted for like any other service contract, which means all costs must be expensed when the service is performed.  The only opportunity to capitalize these expenses on the balance sheet is to book the costs as a prepaid asset and amortize them as the prepaid (software) services are used.

Being forced to expense all costs associated with purchasing and implementing new software poses a significant hurdle to potential buyers of cloud computing software. If the contract is considered a purchase of services, then implementation costs related to the software – which can often times reach seven figures – must also be expensed. The potential for taking an immediate hit to the income statement for such a large dollar amount is more than enough to give many companies pause when evaluating cloud software.

As such, many cloud software providers have also taken steps to simplify the process by moving from software service subscription fees to offering contracts based on software licensing fees. An arrangement which includes a software license is considered “internal use software” and accounted for as an intangible asset. Under the internal use software designation, the typical expense vs. capitalization rules apply and companies are allowed to capitalize and then amortize implementation costs accordingly.

New Accounting Rules Cheat Sheet
With many cloud software vendors offering either a subscription based or license based contract, it is important for perspective buyers to understand the impact to the software’s total cost of ownership. In some cases, a subscription or service-based contract may have a lower total cost of ownership. Some clients may choose to go with the service contract to lower the total amount of cash going out the door, versus other clients which may choose to pay more for a license-based contract in order to absorb the costs on the P&L over time.

To avoid any surprises with accounting for cloud software costs, we advise our clients to obtain a clear understanding of the pricing model from every perspective cloud software vendor and to take a total cost of ownership approach when making any software decision.

Trenegy assists companies in selecting and implementing the right technology solutions. For additional information, please contact us at: info@trenegy.com.