Structuring Cloud Computing Arrangements to Ensure They Have a Positive Impact on Key Financial Indicators
In April 2015, the Financial Accounting Standards Board (“FASB”) issued new guidance* on accounting for fees paid for cloud computing arrangements. How you structure your cloud computing arrangement will determine if the related fees are treated as an operating expense or as a fixed or intangible asset subject to depreciation or amortization. The determination of how these fees are structured may significantly impact earnings before interest, taxes, depreciation, and amortization (“EBITDA”), and other key financial indicators, which could impact financing covenant compliance or other third party operating performance analysis.
If your cloud computing arrangement fees are significant, treating them as an operating expense will significantly decrease EBITDA and operating cash flow. If these fees can be considered software licensing fees, these amounts can be capitalized and amortized, will not impact EBITDA, and will be categorized as an investing activity on the statement of cash flows, not as a reduction of cash flows from operations. Clearly the accounting complexities for cloud computing arrangements should be considered and analyzed prior to the execution of these arrangements to obtain the optimal accounting results.
What determines the accounting treatment of the cloud computing arrangement fees?
In general, arrangements or components of arrangements that meet two criteria are considered to be acquisition of, or licenses of, software. Fees for these arrangements or components can be capitalized as fixed assets or intangibles subject to depreciation and amortization. The two criteria are:
- The customer has the contractual right to take possession of the software at any time during the cloud computing arrangement without significant penalty, and
- It is feasible for the customer to run the software on its own hardware, or to contract with another party to host the software.
Arrangements that do not meet both criteria are considered service contracts and the related fees are expensed over the life of the arrangement.
Cloud computing arrangement fees considered to be for a service contract will reflect the fees as prepaid expenses on the balance sheet and the costs will be reflected as operating expenses on the income statement, reducing EBITDA. In addition, these costs will reduce operating cash flow on the statement of cash flows.
Cloud computing arrangement fees considered to be for software license fees will be capitalized as a fixed or intangible asset on the balance sheet. The cost of the fixed or intangible asset will be treated as an investing activity on the statement of cash flow, resulting in a higher cash flow from operations than a similar cloud computing arrangement fee considered to be for a service contract. The depreciation or amortization of the asset will result in a higher EBITDA than when the cloud computing arrangement fee is considered to be for a service contract.
Note that cloud computing arrangements may include components for set-up, the cloud service access, software access, maintenance, and support. Therefore, there will be judgment and estimating involved in allocating the components of the agreement and analyzing the contract.
As the early adoption provisions of this literature allow application to existing cloud computing arrangements and retroactive restatement we suggest entities with cloud computing arrangements that include elements of internal-use software consider the cost and potential benefit of electing the early adoption provisions.
*FASB ASU 2015-05 Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement, Intangibles-Goodwill and Other-Internal-Use Software (Subtopic 350-40.) For public business entities, the Board decided that the amendments will be effective for annual periods, including interim periods within those annual periods, beginning after December 15, 2015. For all other entities, the amendments will be effective for annual periods beginning after December 15, 2015, and interim periods in annual periods beginning after December 15, 2016. Early adoption is permitted for all entities.