Cloud Computing Arrangements — Implementation Complexities
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:
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).
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.
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:
Deloitte & Touche LLP
+1 203 761 3039
Deloitte & Touche LLP
+1 313 394 5362
Deloitte & Touche LLP
+1 440 334 3489
Deloitte & Touche LLP
+1 469 417 3075
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.
See ASC 350-40-30-4.
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.
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.