It’s time to make decisions about how to use the 2016 IT budgets. You, the CIO, may have already decided which prepackaged software, cloud services, or internally developed programs are best for your company, but now you are forced to obtain approval from the other executives, such as the CFO.
As a public company, the executives are always concerned about the effect of their decisions on the investors. These changes to the financial statements may make the final determining factor of your IT decision, even if it may not be the answer your IT department wants to hear.
The IT world is turning to cloud services to run software programs rather than purchasing large servers that will require high costs to store and maintain. If a company has a chance to ditch the old servers behind, the IT department may dream of a world free from being tied to a physical source.
However, the CFO may now have a different view on this new form of hosting IT needs, because the Financial Accounting Standards Board (FASB) requires the transaction be recorded in a way that may not be the most beneficial to investors.
New Regulations As Of December 15, 2015
For public companies, a new regulation was put into effect as of December 15, 2015 that changes how they will need to record their cloud computing service costs and, ultimately, may affect their decisions related to IT. (Note: this new regulation is only related to internally used software and not software that is sold to customers.)
Ultimately, this new rule makes it harder to capitalize (read: record as a company asset) the costs of cloud computing services.
The new regulation states that in order for cloud computing service costs to be treated under the Generally Accepted Accounting Principles (GAAP) software development rules (i.e. capitalized upon), the customer must have the right to take possession of the software at any time and be able to run the software on its own hardware or contract with another party to host. Otherwise, the cloud computing costs are treated as a service expense.
According to these regulations, the only way the companies would be able to capitalize the cost of cloud computing services is if the services are sold as a package that includes the transfer of the software license. Cloud computing and hosting contracts that do not include sale of a software license should be recorded as a service contract, which means these costs are expensed as incurred – reducing net income for the company (explanation to follow).
Why This Matters
The method of recording the cloud computing costs is important because of its effect on the financial statements.
When You Satisfy The New Regulatory Requirements: Capitalize
If the contract is determined to satisfy the requirements, then the fees will be an intangible asset on the Balance sheet. See GAAP rules below for details on which costs are capitalizable.
That means that depreciation will be recorded on the income statement over time, and the purchase is classified as an investing activity on the Statement of Cash Flows.
Note: Investors like to see these types of investing activities show up on the financial statements because it shows the company has plans for the future. And at the time of purchase, the total value of assets are not affected, which keeps the investors happy.
When You Don’t Satisfy The New Regulatory Requirements: Operating Expense
If it is determined that the cloud computing agreement does not include a transfer of a software license and ownership, then the cost is recorded as an operating expense.
The assets will be decreased by the amount of the total contract, and the cash flows will be considered operating costs. As the upfront implementation and setup costs of a cloud computing solution can be a significant investment, this can have a major impact.
Note: Investors do not like to see operating costs increase, as this often reduces the margin earned off each sale.
GAAP Rules To Capitalize
Once it has been determined that the Cloud Computing agreement does include the transfer of a license, then the costs associated with cloud computing and purchasing the license will follow the GAAP rules related to capitalizing internally developed software.
US GAAP defines 3 stages of software development: Preliminary, Application Development, and Post Implementation:
- The Preliminary stage includes the decisions around allocation of resources, evaluating technology options, and vendor selection. All costs incurred during the Preliminary stage should be expensed right away.
- The Application Development stage includes development, testing, and material costs required to build the software. These costs will all be capitalized on the balance sheet and amortized over the life of the software.
- Finally, costs in the post-implementation, such as maintenance, will be expensed as incurred.
Will This Affect Cloud Computing Adoption? We Think So.
In an article recently published by Network World, “Will New Accounting Rule Slow Adoption of Cloud Computing,” author John Dix shares our concern that this new regulation can make it harder for companies to take the big leap to cloud computing.
Dix shares the concern that due to the new regulation, cloud computing might not be a chosen path due to that the significant implementation costs that are required to begin cloud computing. (As, according to the GAAP rules, they would be considered to be in the preliminary stage of software development and therefore are expensed as incurred instead of over time.) Dix tells us that EAS, a Fortune 200 global company, capitalized $4.5 million of cloud-computing implementation costs in 2015 that they would not be able to capitalize today under the new regulation.
The article calls for FASB to reconsider this issue and release additional regulation to clarify the treatment of cloud computing costs. But as the regulation stands currently, finding a cloud-based service agreement that does transfer the right of the license is a smart choice to increase the likelihood of capitalizing the costs. We don’t want your company to give up on the idea of becoming cloud-based, but it is important to be aware of the new regulation. As more time passes, we will continue to observe the actual implementation and how it affects the switch to cloud services.
Traditional Approach vs. Modernization
During the executive meeting to determine if the company should choose a cloud computing contract or a more traditional approach of buying servers and hosting the software themselves, the effects of the transactions on the financial statements will be compared.
The purchase of a traditional data center is a capitalized cost which is then depreciated over the useful life. This equipment will be capitalized and depreciated over the life of the asset, which is usually a longer period of service than a software contract. This allows for less depreciation expense per year because the costs are spread over a longer period of time.
This is also a more traditional approach, which the investors may feel is a safer choice because the costs will be known at the beginning, compared to cloud computing costs which may be based on the use and may be harder to predict over the long term.
Overall, IT decisions are not made in a silo, but the entire executive suite brings different viewpoints to the table. This article was meant to bring awareness to the new accounting regulation, which may affect your company’s decision to switch to cloud computing services. There are of course other factors that will determine if your company is ready to make the leap to cloud-based services.
Ultimately, if your company will save money, time, and stress in the long run by switching, then it doesn’t really matter how accounting records the purchase, because if cloud services will create additional income for your company then it is probably the right decision. Your investors might see cloud computing as a necessary step and be encouraged that your company is making the decision.
Disclaimer: The advice provided on this blog is general advice only. It has been prepared without taking into account your objectives, financial situation, or needs. Before acting on this advice you should consider the appropriateness of the advice, having regard to your own objectives, financial situation and needs. Consult an accounting professional.