I was always a fan of rules as a kid. Structure and limits were something I appreciated, which is why I loved hanging out in my pack 'n' play, according to my mother. When I knew my boundaries, I knew how to play the game. Accounting is very similar. Accountants are expected to adhere to GAAP (Generally Accepted Accounting Principles) and follow Accounting Standards.
These days, there is a standard getting much more attention than the rest: Accounting Standards Update (ASU) 2015-05, Intangibles - Goodwill and Other - Internal-Use Software - Customer's Accounting for Fees Paid in a Cloud Computing Arrangement. The "cloud" is becoming more and more attractive to companies due to its flexibility and ease of use. Cloud companies are equally happy with the arrangement, since they are offering a service with expected monthly cash flows. Over time, customers become more and more ingrained with their cloud offerings, and it becomes more and more difficult to switch vendors, which cloud service providers love even more.
Accountants, however, are tasked with the difficult task of managing the balance sheet and income statements. Even though the IT department might prefer cloud service offerings, this is moving dollars from the balance sheet to the income statement. In other words, assets are turning into expenses. From a Finance perspective, companies, especially those that are publicly traded, focus their attention on EBITDA. EBITDA is an acronym for Earnings before Interest, Taxes, Depreciation, and Amortization. Investors follow EBITDA and companies want the number to hit certain thresholds as it relates to revenue. When a company pays cloud costs, it erodes EBITDA. However, depreciation and amortization related to perpetual software licenses and assets is "below the line" and does not affect EBITDA.
So what does this all mean? It means that accountants prefer the purchase of assets, and that's why all of us are fervently referring to ASU 2015-05, Intangibles - Goodwill and Other - Internal-Use Software - Customer's Accounting for Fees Paid in a Cloud Computing Arrangement. The ASU provides guidance of determining whether an asset exists in a cloud computing arrangement. To apply, the following criteria must be met:
- The customer has the contractual right to take possession of the software at any time during the hosting period, without significant penalty.
- 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.
Already you can see that an "on-prem" solution can be capitalized and should be capitalized. If the vendor is purely providing a service specific to that vendor, then the payment amounts should be expensed as a prepaid.
If both criteria are met, then certain activities should be tracked and quantified to ensure that the optimal amount of implementation costs are being capitalized.
It takes diligence, tracking, and pulling apart the layers of the onion to get the most out of your cloud computing arrangement from an accounting perspective, but it can be done. More often than not, vendors are willing to negotiate terms to meet the criteria, so don't be afraid to ask and don't be afraid to have that discussion. Honestly, I have found that these vendors are getting more and more questions related to capitalization ... and we all know they want to make that sale!
Republished with permission from the TBM Council