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Most companies use cloud-based applications. The accounting profession has formulated new guidance on how to treat the cost of cloud-based applications. The Financial Accounting Standards Board (FASB) recently issued Accounting Standard Update (ASU) 2015-05 to offer guidance on customer’s Cloud Computing Arrangement (CCA) fees.

Previously, there was limited guidance available from the customer’s perspective. Preceding accounting treatment for CCAs included recording the agreement as a service contract, and therefore, increasing the prepaid expense account initially. In subsequent periods, the prepaid balance amortized as software expense over the contractual term. FASB has amended their opinion and now contends that if certain conditions exist, customers should record the underlying software as an intangible asset. Consequently, ASU 2015-05 seeks to make the accounting for software licenses uniform with other intangible asset licenses.

ASU 2015-05 criteria

ASU 2015-05 specifies two criteria that qualify CCAs as multiple-element arrangements to purchase both a software license and a service. A CCA will fall within the scope of internal-use software guidance (ASC 350-40) if both of the following criteria are met:

  • The customer has a contractual right to take possession of the software at any time during the CCA period without significant penalty. (In this case, the term “significant penalty” refers to the ability of the customer to take control of the software element and apply it separately without incurring significant cost in the process or recognizing a significant reduction in value.)
  • It is feasible for the customer to run the software on its own hardware (or to contract with another party to host the software).

If both of the criteria are met, cost incurred by the company should be allocated between the software license and the service elements. Any other arrangements shall be treated as a service contract and separate accounting treatment for the software license is not permitted.

Costs incurred by the customer in a CCA that includes a software license should be allocated between the license and service elements, based on the respective fair value of each element. It is likely that determining the fair value will require the application of estimates. For example, management may consider information such as the negotiation process with the vendor in determining the fair value of the software license or simply ask the vendor to breakout the value of each component in the contract.

Financial statement implications

There is a potential for significant financial statement implications for CCAs containing a software license. For instance, acquisition of a software license would be recorded as an intangible asset on the balance sheet and depreciated/amortized over the life of the asset (presumably the contract period) whereas a service agreement would be treated as a prepaid expense and an operating expense on the income statement. Furthermore, the software license would be presented as an investing activity on the statement of cash flows while the service contract would be presented as an operating activity.

As companies transition to the new accounting standard, it is necessary to consider the disclosure requirements for recent accounting pronouncements. In addition, any company that expects to have a change in classification due to ASU 2015-05 should evaluate the effect on other areas of the organization, as it is likely that the impact will not be isolated.

This new guidance is effective as of 2016 for all public companies and 2017 for private companies, with early adoption permitted. However, all entities may elect for early adoption and transition to the new guidance either retrospectively or prospectively. Before adopting this new guidance, a company should do a cost benefit analysis to determine if the application of this rule is cost beneficial.