Navigating ASC 606 Revenue Recognition: A Comprehensive Guide for CFOs
Accounting for Cloud Computing Arrangements Under New Guidance
Your company's data and systems aren't relegated to terra firma anymore. For the most part, that's a very good thing. Aside from ditching expensive servers and a never-ending headache for your IT department, cloud computing means your data is always accessible, flexible, and scalable according to your needs.
The catch – because there's always a catch – comes from the differences between cloud computing arrangements (CCAs) and the more traditional software solutions that many companies are still used to. Sure, the functionality between the new and the old might be almost identical, but there are plenty of accounting implications and differences between them, especially on the balance sheet and income statements.
So to keep you on the accounting straight-and-narrow, we're going to run through accounting for cloud computing arrangements under the new guidance, help keep you compliant, and ensure that this nifty technology is nothing but clear skies for your accounting function.
A Bit of Background: Asset Purchases vs. Service Contracts
It wasn't so long ago that the term cloud computing sounded like something straight out of science fiction to most. These days, however, if cloud computing isn't already the norm, then it's very close to it. And just as the technology itself has advanced in recent years, so have the ways that companies prefer to use it.
Considered a type of purchased software license, it wasn’t until 2015 that GAAP issued guidance to determine whether fees paid for CCAs were a service contract or an intangible asset. Generally speaking, traditional, internal-use software with the purchase of a license – meaning, the customer ran the software on their own systems and servers – resulted in a company recognizing an intangible asset. However, in lockstep with the rapid rise of SaaS and other less permanent arrangements, many companies – perhaps even most – now prefer annual, quarterly, or even month-to-month subscription-based service arrangements, where there is no actual purchase of a license.
In these cases, companies must account for the arrangement exclusively as a service contract. In other words, there is no impact on the balance sheet except in certain cases – for example, an asset for prepayment of the hosting service or a liability for usage-based fees incurred but not yet paid. Absent these circumstances, companies expense the hosting service under the CCA as incurred.
Clarifying Guidance: ASU 2018-15
One of the most common inconsistencies in accounting for CCAs stemmed from the significant upfront costs that companies incurred while implementing them. While there was specific guidance on the accounting for costs related to licensed software – ASC 350-40 – no such guidance existed for the implementation costs for CCAs using the newer, subscription-based service contract models. Because of that lack of guidance, accounting practices varied greatly between companies and how they accounted for costs related to CCAs.
To address that variance, the FASB issued an accounting standards update, ASU 2018-15, amending ASC 350-40 to address the accounting implementation costs incurred in a CCA classified as a service contract. This updated guidance aligned the accounting for implementation costs on service arrangement CCAs with the existing guidance on capitalized costs in developing or obtaining internal-use software.
In fact, the ASU amends ASC 350 to include the implementation costs of a service contract CCA, stating that a company should apply ASC 350-40 to identify which implementation costs to capitalize in a CCA considered to be a service contract.
Summarizing the Accounting
Naturally, this relatively new guidance can feel like something between a rude awakening and a jolt to the system for companies accustomed to those intangible asset line items that bulk up their balance sheets. However, maybe it's best to look at it as a take-the-good-with-the-bad type of scenario. Companies might lose the ability to pump up their assets with purchasing licenses but, to the FASB's credit, they can at least potentially capitalize some of the significant implementation costs on service contracts.
Granted, no matter the benevolence from the FASB, it might still feel like a bit of a maze as you sort through the scope of the guidance for software arrangements and, thus, your CCAs. So to save you a bit of time and frustration, we've created a handy flowchart you can use to identify what guidance pertains to you and your cloud computing arrangements. Enjoy.
Of course, you can also use our flowchart to help inform a decision between a traditional purchase and a service contract. Whether you use it to help determine how to account for an existing arrangement or to inform a decision, though, there are some distinct differences between the different applications of cost guidance for software arrangements that we want to zoom in on.
Traditional Licensed Software
The older guidance that addresses traditional licenses separates the types of activities and accounting treatments into three separate project stages, as seen in the table below.
|Types of activities in stage
Expense - internal and external costs
Capitalize – external direct costs of materials and services, payroll and payroll benefits for those directly associated with development, interest costs under ASC 835-20
Expense – training, data conversion, G&A or overhead costs
Expense – internal and external costs
CCAs as Service Contracts
While the guidance on internal-use software costs focuses on sequential stages of a project, CCA implementation costs don't necessarily occur in such a linear fashion. Put another way, qualified implementation costs may occur at different stages of a project.
To account for this dynamic, you should assess the nature of the costs incurred rather than the timing of them. This will help you identify which costs qualify for capitalization, as demonstrated by the following examples:
Generally NOT capitalizable
External direct costs of materials
Costs for data conversion activities
Third-party service fees to develop software
Costs for training activities
Costs to obtain software from third parties
Costs for software maintenance
Coding and testing fees directly related to software**
**As an example, coding and testing fees directly related to software could include the direct costs of employees who perform coding and testing functions to ensure they are working as indicated or expected. Specifically, such payroll and payroll-related benefit expenses are generally considered to be capitalizable.
Financial Statement Impact
Putting everything together, you obviously must keep in mind the impact of your software arrangement options on your financial statements. To save your eyes a bit of strain in researching those impacts, we've summarized them for you in a quick reference chart.
Traditional licensed software
Cloud computing arrangement (as service contract) ASU 2018-15
Fixed or intangible asset
Prepaid or other asset
(qualified implementation costs only)
Depreciation or amortization
Cash flow statement
**A quick note on operating expenses for CCAs under ASU 2018-15: the new cloud computing guidance requires companies to present implementation costs related to a CCA in the same financial statement line items as the CCA service fees. This results in key differences from the presentation of costs related to licensed software. Also, the presentation requirements could impact key metrics such as EBITDA since you will not include the recognition of capitalized CCA costs over time within depreciation or amortization expense.
Impairment Considerations for CCAs as Service Contracts
Remember, the accounting considerations for CCAs aren't confined to the specific guidance in ASC 350-40 and ASU 2018-15. For instance, the capitalized implementation costs for CCAs are also subject to the impairment model in ASC 360. And in case you need a bit of a refresher course, keep in mind that you must assess impairment under ASC 360 at the asset grouping level or, put differently, the lowest level where separately identifiable, independent cash flows exist.
You perform impairment assessments when you identify events or conditions that may trigger the need to see if the asset group is recoverable. For CCAs in an asset group, an event or condition that may trigger this assessment could include:
- The hosting arrangement isn't expected to provide substantial service potential
- A significant change in the manner you use or will use the hosting arrangement, including abandonment of the CCA service or even a component or module of the CCA service.
For that last point, you consider a CCA, including a component or a module of a CCA, as abandoned when you stop using the service. Also, if you have a plan to abandon the entire CCA or even just a component of it, consider whether to adjust your estimate for the amortization of the implementation costs – the ones that you previously capitalized – to a shorter period that's more consistent with the expected abandonment date.
Adoption & Transition
Now we're not trying to stress you out or anything, but if you're a public business entity with a calendar year-end, then the CCA accounting standard has a 2020 effective date for your annual and interim financial statements. Other entities have a bit more leeway, an additional year to adopt the guidance for annual financial reporting, but as you know, time flies by, so it's time to get familiar with the applicable guidance. No matter when the standard is effective for your company, though, you can choose to adopt the new guidance either:
- Retrospectively, or
- Prospectively to eligible costs incurred on or after the date you first apply the guidance
Other Operational Challenges of CCAs
Before we send you off to fend for your own, we would be remiss if we didn't discuss how to address a few other operational challenges associated with cloud computing arrangements along with considerations to think about.
Determining What to Capitalize vs. Expense
- Assess the nature of the costs incurred like, for example, identifying implementation costs versus training or reengineering costs.
- Identify direct labor, incentive compensation, engineering costs, and meals & entertainment costs.
- Segregate costs where there are multiple components, including equipment, cloud solutions, hardware, software, and third-party service providers.
- Estimate implementation costs when a CCA invoice or contract doesn't distinguish between implementation fees and fees for the hosted service.
CCAs with Multiple Modules or Components
- Determine the value of multiple instances of the same hosted CCA service you use for different business units or geographies. Remember, this could be in different stages of implementation.
- Determine when amortization should begin for each module or component of the hosted CCA service.
- Determine how to account for abandonment if you only abandon a portion of the CCA.
Impacts on Cross-Functional Activities
- Develop a plan or strategy for data conversion, migration, and integration into other systems.
- Educate other functions of your company – IT, procurement, and others – on the accounting considerations.
As you know, Embark takes great pride in helping companies sort through the most complex accounting issues and come out the other side as stronger, more successful organizations. Needless to say, these insights on accounting for cloud computing arrangements are no exception. And as always, if you prefer someone to take the wheel and steer you in the right direction, our team is ready, willing, and able to roll-up our sleeves whenever you need us.