Cloud Computing Arrangements — Implementation Complexities
Background
Did you know that the accounting guidance on identifying and
classifying the capitalizable costs incurred to implement a cloud computing (or
hosting) arrangement that is a service contract can require significant judgment
and that inappropriate application of that guidance can lead to the incorrect
accounting for capitalized costs? ASU 2018-151 aligns the recognition of costs incurred to implement a cloud computing
(or hosting) arrangement that is a service contract (hereinafter referred to as
a CCA) with the guidance on capitalizing costs associated with developing or
obtaining internal-use software (see Deloitte’s September 11, 2018 Heads Up for
additional background). However, capitalized costs associated with a service
contract differ in character from costs that are capitalized in connection with
developing or obtaining internal-use software. As a result, costs that are
capitalized in connection with implementing a CCA are likely to be presented
differently (both in the recognition on the balance sheet and statement of cash
flows and in the subsequent derecognition through the income statement) from
costs incurred to develop or acquire internal-use software. Many entities are
implementing software solutions that combine hosted software in a CCA with owned
or licensed (i.e., internal-use) software. The complexities of these
arrangements should be carefully scrutinized to appropriately identify whether
the implementation activities should be associated with the CCA or with
internal-use software.
Distinguishing Internal-Use Software From Software Subject to a CCA
While ASU 2018-15 clarifies what constitutes a “hosting arrangement,” it does not
modify the scoping guidance that differentiates a software license (i.e.,
internal-use software) from a CCA. That is, under ASC 350-40-15-4A, even if
software is being hosted on a third party’s platform, an entity will still need
to assess whether (1) it “has the contractual right to take possession of the
software at any time during the hosting period without significant penalty” and
(2) “it is feasible for the [entity] to either run the software on its own
hardware or contract with another party unrelated to the vendor to host the
software.” If both of these criteria are met, the related software is considered
internal-use software even if it is being hosted by a third-party vendor or the
hosted software is interacting with software that is subject to a CCA (i.e.,
software that the entity cannot take possession of). If one or both of these
criteria are not met, the software is considered part of a hosting arrangement
that is a service contract.
Identifying Capitalizable Implementation Costs
Because the relevant guidance was issued over 20 years ago, it is likely that
many entities have existing accounting policies in place to address the
accounting for the development, implementation, and acquisition of internal-use
software. Since ASU 2018-15 aligns a customer’s recognition of implementation
costs incurred in a CCA with the legacy internal-use software guidance, entities
may not need to create new accounting policies in response to the ASU. However,
these policies have not historically applied to CCA implementation costs, and
thus new processes might need to be put in place to adapt existing accounting
policies to address CCA arrangements. Specifically, entities will have to
establish processes to distinguish CCA implementation costs incurred during the
preliminary-project and post-implementation-operation stages from those incurred
during the application development stage. This is because costs incurred during
the preliminary-project and post-implementation-operation stages need to be
expensed as incurred while certain costs incurred during the application
development stage must be capitalized.
In accordance with ASC 350-40-30-1, the types of costs that can be capitalized
during the application development stage include but are not limited to
“[p]ayroll and payroll-related costs (for example, costs of employee benefits)
for employees [or third-party service providers] who are directly associated
with and who devote time to” implementing the CCA (“to the extent of the time
spent directly on the project”). In addition, in a manner consistent with the
requirements in ASC 835-20, applicable interest costs incurred during the
application development stage should be capitalized as part of the CCA. By
contrast, any costs associated with data conversion (other than software
acquired for such conversion) as well as any training costs should be expensed
as incurred.
In some instances, entities make payments directly to a CCA
vendor that will provide both the implementation services and the on-going CCA
services. Because not all costs incurred during the application development
stage can be capitalized, entities will need to determine how best to identify
what portion of the fees paid to the CCA service provider must be capitalized
and what portion must be expensed as incurred. This will typically require an
entity to identify the activities the service provider is performing that are
not eligible for capitalization (e.g., training costs) and allocate the fees
paid to the provider to the various activities on the basis of each element’s
stand-alone selling price (which may not be the contractual price).2
For some large-scale cloud deployments, implementation costs can be significant
(sometimes higher than the cost associated with the CCA service fee), thereby
underscoring the importance of appropriately identifying capitalizable
implementation costs.
CCA Service Costs Incurred During the Application Development Stage
An entity may sometimes be required to begin paying the
ongoing CCA service fee to the service provider during the application
development stage. If the CCA service fee is paid before “go-live” (i.e.,
when the hosted software subject to the CCA is ready for its intended use),
questions arise about whether the service cost incurred pre-go-live should
be capitalized as an implementation cost or expensed as incurred.3
ASC 350-40-30-1 indicates that services that an entity consumes in developing
a CCA solution should be capitalized as part of the CCA. However, judgment
is required to determine whether service costs incurred during the
application development stage are in fact services that the entity consumed
in developing the CCA rather than to access the CCA during application
development. In many instances, access to the hosted solution is provided to
allow a customer to implement its solution. This would be analogous to
allowing a tenant to access its rented space to construct leasehold
improvements before it occupies the space. In these situations, it is
generally appropriate to expense the CCA service fees incurred during the
application development stage as incurred.
However, there may be circumstances in which it would be appropriate for an
entity to capitalize CCA fees that are incurred during the application
development stage. This could be the case if, for example, (1) the entity is
not able to access the CCA platform during the application development stage
and derives no benefit from the CCA service fees paid during that period
(e.g., if the entity is not able to access the platform to customize or
enhance the CCA during the application development stage) or (2) the CCA
service provider is performing implementation activities that qualify for
capitalization during the application development stage (e.g., the provider
is performing customization services). In these instances, the CCA service
fees paid during the application development stage may be no different from
an expense that is prepaid to the CCA service provider. Careful evaluation
of the facts and circumstances is required to conclude that CCA service fees
paid during the application development stage should be capitalized, since
we expect that most CCA services fees incurred during this period would be
expensed as incurred.
Classifying Capitalized Implementation Costs in a CCA That Is a Service Contract
The model used to determine which costs are capitalized in connection with
implementing a hosting arrangement is the same regardless of whether the
underlying software qualifies as internal-use software or is provided as part of
a CCA. However, since there are differences in how the costs are characterized,
it will be important to analyze what the costs are related to. This is because
capitalized implementation costs related to a CCA are classified and presented
differently from capitalized costs associated with developing or obtaining
internal-use software. Eligible costs incurred to implement a CCA should be
capitalized as a prepaid asset and characterized in a company’s financial
statements in the same line item in the income statement as the hosting service
expense (e.g., as an operating expense). This is consistent with the
classification of other service costs and assets related to service contracts.
That is, these costs would be capitalized as part of the service contract, and
the financial statement presentation of the cash flows, the resulting asset, and
related subsequent expense presentation would be consistent with the ongoing
periodic costs of the underlying CCA.
By contrast, any capitalized costs incurred that are associated with developing
or obtaining internal-use software become part of the underlying software asset
(which is generally considered an intangible asset). As with other intangible
assets, the costs incurred to obtain a software asset are generally capital in
nature and thus are treated similarly to the costs of acquiring property, plant,
and equipment.
Connecting the Dots
ASU 2018-15 aligns the recognition of implementation costs incurred in
connection with a CCA with the recognition of costs incurred to
implement an internal-use software solution. However, because a CCA is a
service contract while an internal-use software solution gives rise to a
software asset, it is likely that the presentation of the subsequent
expensing of the capitalized implementation costs will differ. The ASU
indicates the following regarding the presentation of implementation
costs capitalized in a CCA that is a service contract:
-
The balance sheet line item for the customer’s presentation of capitalized implementation costs should be the same as that for the prepayment of fees related to the hosting arrangement.
-
The expense for the capitalized implementation costs and fees associated with the hosting arrangement should be presented in the same line item in the statement of income.
-
The manner in which a customer classifies the cash flows related to capitalized implementation costs should be the same as that in which it classifies the cash flows for the fees related to the hosting arrangement (i.e., operating cash flows).
Because the presentation of capitalized implementation costs differs depending on
whether the costs are incurred in a CCA that is a service contract (prepaid
assets, operating expenses, and operating cash flows) or in an internal-use
software license (intangible assets, amortization expenses, and investing cash
flows), it is crucial for entities to appropriately identify which activities
and associated costs are modifying internal-use software and which are
associated with implementing a CCA.
Consider the following examples:
Example 1
Entity A is implementing a large-scale enterprise
resource planning (ERP) solution that will be hosted in
the cloud and accounted for as a CCA that is a service
contract. Entity A owns an in-house software module that
will be hosted and adapted to be used with the ERP
solution. While A will retain the right to retake
possession of its in-house module, it will not have such
rights to the hosted ERP solution since those will be
retained by the service provider. During the application
development stage, A incurred (1) $250,000 of internal
resource costs (payroll and payroll-related costs) to
modify the code of the in-house software that will be
moved to the hosted environment and used with the ERP
and (2) $450,000 of costs that are eligible for
capitalization in accordance with ASC 350-40 to
implement the ERP.
Entity A will need to separately account for the costs
incurred to modify the owned software module and the
costs to implement the ERP solution (i.e., the costs are
allocated to different assets). In this example, both
sets of implementation costs meet the criteria in ASC
350-40 to be capitalized during the application
development stage. However, given the nature of the
software (i.e., an owned in-house module rather than a
CCA), accounting for the related costs will result in
different classifications and characterizations in the
financial statements. The costs related to coding the
owned in-house module ($250,000) will be capitalized as
costs associated with internal-use software, and
subsequent amortization will be presented in a manner
consistent with amortization of other internal-use
software. The costs incurred to implement the ERP
($450,000) will be capitalized as a prepaid asset and
presented in the same line item in the income statement
as the CCA service cost (e.g., an operating
expense).
Example 2
Entity B entered into a CCA that is a service contract
for a sales solution for the company’s workforce with a
service provider. To facilitate the setup and
implementation, B will pay the provider a fixed fee of
$400,000 to perform certain activities, including data
conversion, training, and implementation (coding).
In this example, B should identify the
portions of the fixed fee that are related to the
following activities: (1) data conversion, (2) training,
and (3) implementation (coding), because not all costs
incurred during the application development stage can be
capitalized. In accordance with ASC 350-40, B determines
that the data conversion and training activities the
provider is performing are not eligible for
capitalization, but the implementation activities are.
Entity B will allocate the fixed fee ($400,000) it paid
to the provider to the three activities on the basis of
each activity’s stand-alone selling price.4 In accordance with the guidance in ASU 2018-15,
the allocated implementation costs incurred to code the
hosted software will be capitalized as a prepaid asset
and the costs allocated to the data conversion and
training activities will be expensed as incurred.
Example 3
Company A has a perpetual license to an ERP system that
has historically been hosted in A’s own data center and
is migrating that system to a third-party hosting
provider (Provider B). During the application
development stage, A incurs $500,000 that qualifies for
capitalization in accordance with ASC 350-40 to modify
the ERP system to work in Provider B’s environment.
Company A has the contractual right to move the ERP
system either back to its own data center or to another
third-party hosting provider (e.g., Provider C) and
concludes that it is feasible to do so without incurring
a significant penalty or a diminution of utility or
value. If the ERP system is moved to another third-party
hosting provider, A will retain the benefits from the
modifications made to the system. Company A concludes
that the $500,000 incurred during the application
development stage should be capitalized as internal-use
software and amortized over the software’s expected
useful life.
Where to Find Additional Information
If you have questions about cloud computing arrangements or ASU 2018-15, or need
assistance with interpreting or implementing its requirements, please contact
any of the following Deloitte professionals:
Chris Chiriatti
Managing Director
Deloitte & Touche LLP
+1 203 761 3039
|
Andrew Hubacker
Partner
Deloitte & Touche LLP
+1 313 394 5362
|
Elena Cilenti
Senior Manager
Deloitte & Touche LLP
+1 440 334 3489
|
Taylor Paul
Senior Manager
Deloitte & Touche LLP
+1 469 417 3075
|
Footnotes
1
FASB Accounting Standards Update No. 2018-15,
Customer’s Accounting for Implementation Costs Incurred in a
Cloud Computing Arrangement That Is a Service Contract — a
consensus of the FASB Emerging Issues Task Force. ASU 2018-15 amends ASC
350-40 to address a customer’s accounting for implementation costs
incurred in a cloud computing arrangement (CCA) that is a service
contract.
2
See ASC 350-40-30-4.
3
If an entity pays fees before go-live that are not
related to implementation activities and it does not derive any
benefit from those fees, it should consider whether the fees
represent a prepaid expense that is recognized as a prepaid asset or
expensed as incurred.
4
Entities are required to
allocate costs in hosting arrangements to all
individual elements. ASU 2018-15 changed the
method of allocation from one that is based on
objective evidence of fair value to one that is
based on each element’s relative stand-alone
price.