Is Your Company Accounting Correctly for Software from the Cloud?

As technology continues to advance, organizations are moving their software away from boxed solutions or internally developed software to hosted, cloud-based computing arrangements. SaaS, or software as a service, often reduces infrastructure requirements and can be customized based on a company’s evolving needs.

As companies access cloud-based software, they need to consider whether they are accounting for it correctly.

The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2018-15 to specifically address software accessed through a hosting arrangement, and align the treatment of certain related implementation costs with existing guidance for internal use software (ASC 350-40).  

The new guidance was effective for public companies for annual periods, including interim periods within those annual periods, beginning after December 15, 2019. For private entities, this ASU is effective for annual periods beginning after December 15, 2020, and interim periods in annual periods beginning after December 15, 2021. Early adoption is permitted.

How do I know if the new guidance applies to my company’s software arrangement?

The new guidance applies if an organization is accessing software for internal use (i.e., solely to meet the entity’s internal needs with no substantive plans for marketing the software externally) through a service contract obtained as part of a hosting arrangement that does NOT meet either of the following criteria in ASC 350-40-15-4A:

• The customer has the contractual right to take possession of the software at any time during the hosting period without significant penalty; and
• 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 both of these criteria are not met, the hosting arrangement is considered a service contract and does not constitute a purchase of, or convey a license to, software.

How are hosting arrangements accounted for under ASU 2018-15?

A company’s license, hosting, and related costs for a subscription to a hosting arrangement are recognized as an operating expense over the term the Company has access to the software and services. This has not changed from historical guidance. The expense is typically on a ratable basis over the stated term, unless another pattern of recognition more accurately reflects the consumption of benefits.

The updated guidance treats implementation costs in a hosting arrangement (implementation, setup and other upfront costs) as if they were internal-use computer software project costs under existing ASC 350-40 guidance. This provides a framework for companies to determine whether certain implementation, training or data conversion costs for cloud-based services contracts should be expensed as incurred, or capitalized and recognized over the term of the arrangement.

Applicable implementation costs should be capitalized and expensed over the term of the arrangement. They should be presented on the balance sheet in the same way as software subscription fees, such as prepaid expenses or other assets. The expense recognized as these costs are amortized should be reported in the same income statement line item as the subscription fees. In contrast to internally developed software, these costs would not be reflected as an identifiable intangible asset or component of property, plant and equipment.

The update also provides guidance for how these costs are reflected on the statement of cash flows.  Capitalized implementation costs for a hosted SaaS arrangement are considered operating activities, and the associated expense is a component of overall net income (loss). This is in contrast to internally developed software costs, for which the cash outlays are reported as investing activities, and the associated amortization would have been presented as an adjustment to reconcile net income (loss) to operating cash flows by backing out the effects of the amortization.

Which implementation costs can be capitalized, and how should the expense be recognized?

Using the framework for internally developed software, hosting arrangement implementation costs should only be capitalized in the application development stage. Any implementation costs incurred during the preliminary stage or post implementation / operating stage should be expensed as incurred.

It is important to note that administrative, overhead or training costs incurred during any stage should be expensed as incurred. Data conversion costs also cannot be capitalized. This means companies need to carefully review charges incurred internally or by third parties, evaluate different components and determine appropriate treatment.

The capitalized costs should be amortized over the term of the hosting arrangement. Any options to extend or terminate the arrangement should be evaluated when establishing the term as described in ASC 350-40-35-14. Amortization begins once the software is ready for its intended use and substantial testing of the software has been completed. Companies should periodically reassess the estimated term of the arrangement and account for any change in the estimated term as a change in accounting estimate.

How should companies evaluate the implementation costs for impairment?

If the hosting arrangement is not expected to provide substantive service or be used in the manner or extent as originally expected, the company should evaluate these capitalized costs to determine whether the carrying amount of the implementation costs is recoverable.  Recognition and measurement of impairment is done in the same manner as if it was a long-lived asset under ASC 360-10-35.

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