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Cloud Computing – Customer Accounting for Implementation Costs

“Clean up” of accounting guidance is always needed to adapt to changing times. Businesses enter into transactions, both on the initiation and the receiving end, not envisioned decades ago. Computer hosting arrangements (“cloud computing”) is one such example. This post deals with only the customer end of a cloud computing arrangement.

Cloud computing arrangements are considered transactions for software that is “developed or obtained for internal use” as is covered in FASB Accounting Standards Codification (ASC) 350-40. This ASC section originated in early 1998, and was a new perspective and counterpoint to FASB Statement No. 86 that covered accounting for software intended to be sold, leased or otherwise marketed, issued in August 1985. (Aside: this is starting to sound like a trip down memory lane.)

We are now in a world where many, if not most, software product functionalities are delivered through cloud-based arrangements, rather than via physical representations. A gap in guidance existed with respect to costs a customer company incurs to implement cloud-based computer functionalities. The FASB initially tackled this question from the perspective of providing guidance for determining whether the arrangement was more like a service contract or the purchase of a software license. I discussed in an earlier post on cloud computing (Cloud Computing Accounting “Simplification” – Hurt More Than Help?) how to make this determination, as well as the accounting required for the implementation costs based on the guidance issued in 2015.

To paraphrase that post, implementation costs for a service contract are expensed as incurred, but certain implementation costs for software licenses are capitalized in accordance with pre-existing guidance. The 2015 guidance failed to address the inconsistency in handling upfront implementation costs between the service arrangement and the software license when these costs are incurred for the same purposes. Finally, this inconsistency is no more with the issuance of ASU No. 2018-15 in August 2018, which aligns the requirements for capitalizing cloud-based implementation costs across both service arrangements and internal-use software licenses.

Essentially, entities apply the longstanding guidance related to internal-use software to determine which implementation costs are eligible for capitalization. Here are some examples:

  • Obtaining or developing software to access or convert old data to a new system is capitalizable
  • Actual data conversion activities are not capitalizable
  • Certain coding and testing activities during the development stage are capitalizable
  • Training costs are not capitalizable

What types of costs are capitalizable?

  • External direct costs of materials or services
  • Directly-related internal payroll and payroll-related costs, such as employee benefits

Overhead costs can never be capitalized, even if incremental to the cloud-based implementation efforts.

Once capitalized, these costs are amortized over the expected benefit period from access to the software, generally on a straight-line basis. Additionally, the capitalized costs are subject to impairment testing under guidance covering other long-lived assets.

This new guidance also stipulates financial statement presentation required for the capitalized costs, as follows:

  • Capitalized costs should be classified in the same line on the balance sheet as any prepaid amounts for the hosted cloud-computing service arrangement.
  • Amortization expense should be presented in the same income statement line as the fees for the associated hosted service.
  • Cash flows associated with the implementation costs should be included in the same statement of cash flows category as cash flows for the fees of the related hosted agreement – generally operating cash flows.

Of note, for companies with EDITDA as an important measure, amortization expense related to the implementation costs is not presented with depreciation and amortization expense related to property and equipment or other intangible assets, so would not be added back to EBIT.

The new guidance expands financial statement disclosure requirements to address material hosting arrangements and most of the same disclosures related to implementation costs as required for property and equipment and impairment losses.

The required effective date of the new guidance for nonpublic companies begins with calendar year 2021 but early implementation is allowed for any financial statements not issued as of the release date in August 2018.

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