The Financial Accounting Standards Board (FASB) changed a rule in December that will make it harder to capitalize the cost of cloud set-up and implementation expenses, a change that may encourage some enterprises to opt instead for traditional on-premise software.
The FASB Accounting Standards Update to “Intangibles – Goodwill and Other – Internal-use Software (Subtopic 350-40)” addresses “Customer’s accounting for fees paid in a cloud computing arrangement.” And while the update didn’t set out to address how to account for cloud migration costs, the new rules, combined with the FASB’s decision “not to provide additional guidance on the accounting for upfront costs,” will mean enterprise shops can no longer depreciate some fees involved in a cloud migration.
Hugo Vasquez, Deputy CIO and VP of Technology and Services for AES, a Fortune 200 global power company, said prior to the change his company was able to capitalize the cost of a cloud migration project and write off that investment over three years. “Now with the new rules, the project itself cannot be capitalized,” Vasquez says.
How big a deal is that? Vasquez says AES last year migrated to Workday’s cloud-based human resources tool. “We were able to capitalize around $4.46 million to implement the project, which went live at the beginning of this month. Our integrator was Deloitte, and we capitalized those costs and the labor of our own people, so we had an incentive to move forward with a cloud solution. But today I couldn’t capitalize that $4.46 million. And that change is resulting in a reduction in projects in our company to move to a cloud computing model.”
Google, one of many companies that commented on the suggested change before it went into effect Dec. 15, agreed that the shift will dampen interest in cloud computing services. In a comment letter to the FASB submitted by Google, Director of Finance Amie Thuener wrote: “We believe that the Proposed Standard could result in a disincentive to purchase hosted cloud computing arrangements if companies interpret the wording … to mean that implementation costs should be expensed as incurred” (versus capitalized and depreciated).
A host of other large companies, from Visa to Salesforce to Groupon, also weighed in on different aspects of the rule change, collectively suggesting, at the least, that more work needs to be done on this specific issue, say nothing of the larger question about how to account for cloud services going forward.
The intent of the change
The FASB Accounting Standards Update in question set out to clarify the rules because “existing GAAP (generally accepted accounting principals) does not include explicit guidance about a customer’s accounting fees paid in a cloud computing arrangement.” (FASB sets the accounting rules for public companies that the Securities and Exchange Committee enforces.)
In essence the Update concludes that, if a cloud computing arrangement includes a software license, then the customer should “account for the software license element of the arrangement consistent with the acquisition of other software licenses.” Regarding the latter, a company with, say, a $30 million license for an on-premise Oracle product, may capitalize that as an asset and depreciate $10 million per year over three years, recognizing that as an expense on their income statement.
The Update continues: “If a cloud computing arrangement does not include a software license, the customer should account for the arrangement as a service contract.”
One of the perceived advantages of cloud computing is the ability to shift from capital-intensive infrastructure/software investments to a service subscription model paid out of the operating budget, so in and of itself this guidance isn’t too surprising. But the Update goes on to say:
“Some stakeholders wanted the scope of this Update to be expanded to address a customer’s accounting for implementation, set up, and other upfront costs that often are incurred by customers entering into cloud computing arrangements. The activities that entities perform in conjunction with entering into a cloud computing arrangement include training, creating or installing an interface, reconfiguring existing systems, and capturing and reformatting data. The board observed that to the extent a cloud computing arrangement transfers a software license, Subtopic 350-40 provides guidance on how to account for costs such as those resulting from training, data capture, and conversion activities.
“In deciding not to provide additional guidance on the accounting for upfront costs incurred by customers entering into cloud computing arrangements that do not transfer a software license to a customer, the Board noted that initial costs incurred in service arrangements are not unique to cloud computing arrangements. Consequently, the scope of that issue is much broader than the scope of this Update. The Board decided that the scope of this Update should not be expanded to address the range of implementation and setup costs incurred by a customer in a cloud computing arrangement.”
There is, however, disagreement in the comment letters about whether a license is the proper litmus test for cloud service accounting. In HP’s comment letter, Senior Vice President, Controller and Principal Accounting Officer Jeff Ricci writes, “as a vendor, HP generally believes its customer is paying for a hosted service, not the acquisition of software or a software license.”
And if no license is involved, the new rules mean companies can no longer capitalize upfront cloud project costs.
Google urges the FASB to delve deeper on this core issue: “We encourage the FASB to consider issuing explicit guidance with respect to the accounting treatment of implementation costs, as these costs can be significant,” Thuener wrote. “We believe capitalizing the software implementation costs and amortizing the corresponding asset over its useful life better reflects the economics of the transaction as expenses are recorded in a manner that reflects the consumption of the economic benefit from the software implementation costs, and therefore is more helpful to readers of financial statements in the analysis of assets and expenses.”
Even companies that agree with using the license model to figure out how to account for cloud services want the FASB to clarify its position on upfront costs given that the “costs can be substantial.” James Hoffmesiter, Corporate Controller for Visa, writes: “While we are supportive of the FASB’s proposal for how to evaluate the arrangement to determine if it is a software license or a service contract, we respectfully request that the FASB consider expanding the proposed standard to include guidance on the accounting for one-time set-up fees incurred by a customer under a cloud computing arrangement.”
Visa goes on to add another wrinkle to the upfront cost discussion. Instead of capitalizing those costs, Visa argues that the “set-up/integration costs should be considered part of the total service cost and recognized over the term of the service agreement,” because the set-up costs “provide a future benefit to the customer in the form of continuous connectivity to the service provider.”
Bigger question going forward
The FASB more or less admitted there is more work to be done when it determined the “scope of this Update should not be expanded to address the range of implementation and setup costs incurred by a customer,” but some of the companies that commented on the update are pushing for a more fundamental review of cloud computing accounting, and more specifically, the role of licenses in that accounting.
Joseph Allanson, Chief Accounting Officer at Salesforce.com, wrote: “We do not agree with the Board’s proposal that a cloud computing arrangement should be accounted for as a service contract if the arrangement does not include a software license. We believe that the delivery mechanism, or the customer’s ability to take possession of the software, should not determine whether a software element is present in a cloud computing arrangement as the functionality of the underlying software is the same regardless of whether the software is delivered via the cloud or on-premise software license. We encourage the board to develop an accounting framework that is based on the economics rather than the form of the software arrangements.”
Groupon’s Chief Accounting Officer Brian Stevens also called for a broader review: “We believe that accounting guidance resulting in a more consistent presentation of software costs, regardless of whether the purchaser elects to maintain the underlying software on its own servers in an on-premise arrangement or contracts to have it maintained on a third party’s servers in a cloud computing arrangement, would reduce complexity for users of financial statements by increasing comparability between economically similar transactions.”
And in a comment letter filed with the FASB, Jay Buth, Vice President, Controller and Chief Accounting Officer with Northeast Utilities System, argues that “both [software] licenses and cloud rights represent intangible assets, and we believe that … these two economically similar types of arrangements should be given similar accounting treatment. We do not believe an entity’s lack of ownership, title or license to software should preclude capitalization.”
Vasquez of AES hopes the FASB reviews the decision soon because it is “affecting our costs and our projects, which is affecting our people, our morale.”