Traditionally, businesses procuring IT and other infrastructure have only been challenged one decision - purchase or lease? From a financial perspective, the choice was unpretentious: lease, because it did not require up-front capital and potentially allowed assets to be kept off balance sheet before AASB16 came along. A purchase decision meant an up-front investment of capital and a depreciating asset on the balance sheet.
Nonetheless, with the advancement of technology, a new choice has emerged - cloud services, which can be obtained without buying or leasing. As an alternative of expensive data centres and IT software licenses, users can choose to simply have a provider host all of their infrastructure and services. No upfront investment is required, just a simple monthly sequence of payments that can be scaled up, scaled back or cancelled as needed some with no lock in contracts. But what does all of this mean for income statements - and your business balance sheet?
Cloud accounting – a contrast business model
Generally, any company acquiring its IT infrastructure would capitalise the costs and amortise them over time. Under the new AASB16 leases standard, a company using a lease or hire purchase arrangement to access IT infrastructure would end up with a similar capitalised asset and amortisation charge over time. Yet, the cloud alternative represents an essentially different business model, one where, unlike the legacy purchase model, a user of cloud services does not ever own the underlying assets.
Acknowledging that this is not yet another article about the new leases standard, it is useful to step through some of the dicey in financial metrics under the leasing standard. While cloud services are likely to result in a differing accounting treatment, the all too familiar concerns in lease accounting are still relevant.
Obviously, accounting can have a significant impact on a business performance metrics, either positive or negative depending on the strategic focus of the organisation and the metrics on which they are assessed - metrics that are progressively in the spotlight given widespread publicity on the impact of the leases standard. Those businesses with a focus on balance sheet metrics typically prefer being able to expense costs as they are incurred: for example, utilities and banks, which are measured on leverage and return on assets. In contrast, businesses with a focus on income statement profitability, and then the deferral of costs, would have a preference to capitalise software costs in line with their current accounting policy. Examples are technology companies and start-ups, which are keenly focused on Net profit after tax profitability.
After all said and done, there is little or no specific guidance in the Australian accounting standards to deal with accounting for a cloud model. But before we look at the possible approaches, we need to understand the terminology.
The types of cloud available in Australia
Most but not all cloud-based technology arrangements are the same; they may cover hardware, software or some combination of the two. Normally, any arrangement involving Amazon Web Services or Microsoft Azure is likely to be a cloud arrangement. Morshona identified the three main types of cloud services below, along with their main characteristics.
Software as a Service (SaaS)
refers to software applications that are delivered over the Internet, on demand and usually via subscription
cloud providers host and manage the software and associated infrastructure, and handle maintenance (e.g. upgrades)
users connect to applications over the Internet (via web browser on smart devices or PC)
Platform as a Service (PaaS)
refers to cloud computing services that supply an on-demand environment that developers can use to develop, test, deliver and manage software applications
allows developers to create web or mobile apps without the need to set up or manage the underlying infrastructure (i.e. servers, storage, networks, databases)
Infrastructure as a Service (IaaS)
refers to the most basic group of cloud computing services
Customer pays for scalable IT infrastructure from a cloud provider on a pay-as you-go basis. This includes servers, storage , networks and operating systems
can be a fixed or scalable capacity
Methods to cloud accounting
Under the Australian accounting standards, IT expenditure costs may be capitalised under either AASB 116 Property, Plant and Equipment, AASB 16 Leases or AASB 138 Intangible assets where a company:
Obtains legal title for hardware and IP licences or otherwise has contractual or legal rights to a specific asset
Expects to derive a future economic benefit, and
The benefit is derived over a period or more than 1 year.
In a cloud agreement, the right to access hardware or software does not generally result in any title transfer or licence being granted - a critical point. The cloud service provider may opt to vary the underlying platforms used, location of assets and technology as long as the contracted service is being delivered.
As such, the ability to apply cost capitalisation principles to cloud arrangements is limited. At best, upfront costs may be capitalised and amortised over the contracted service period. However, ongoing monthly fees should be expensed as incurred as an operating expense, not amortisation. This is distinct from how monthly payments are capitalised upfront in the new world of leasing.
Does the agreement include a software license?
If the cloud agreement includes a software license, which may typically be the case with PaaS or IaaS, the agreement falls within the general principles of intangible accounting. A good rule of thumb, is that cloud software license agreements should be capitalised if both of the following principles are met:
the consumer has the contractual right to take possession of the software at any time during the hosting period without significant penalty, and
It is feasible for the consumer to either run the software on its own hardware or contract with another party unrelated to the vendor to host the software.
If neither of these criteria are met, then typically the software would be recorded as an operating expense.
If the arrangement does not include a software license, as would be most likely the case for SaaS, the arrangement is a service contract and therefore ongoing payments are treated as operating expenses, regardless of whether they are cancellable or not.
Costs of implementation and information migration
Implementation may cover a range of activities, each of which is likely to have a different potential accounting treatment. Typically, implementation includes evaluation of providers, installation and configuration costs, integration with existing systems and middleware, training, information migration and customisation.
Below illustrates what costs are typically capitalised and expensed. Determining which activities in the implementation process are eligible for capitalisation requires judgement and an analysis of the nature of costs incurred.
Stage of implementation process
Preliminary project stage
Internal/external costs prior to selection of a provider
Cost treatment
Expense as there is no specific future benefit at this stage
Installation and implementation
Internal and external costs incurred, modify provider offerings or develop bridging modules to existing systems or bespoke additional capability
Configuration and set up of provider offerings and customisation
Cost treatment
Capitalise, where code is developed internally for which the provider does not obtain IP rights
Judgemental depending on extent and substance of modifications and incremental capability being added
Training costs at implementation
Employee training costs
Development of training materials / content
Cost treatment
Expense employee training costs as there is no intangible asset controlled by the company
Capitalise costs of developing training materials, e-learns and content that is retained by the company
Data conversion costs
Including purging or cleansing of existing data, reconciliation or balancing of the old data and the data in the new system, creation of new or additional data, and conversion of old data to the new system
Cost treatment
Expense as there is no future benefit obtained in migration to a system that is not owned by the user
Post implementation - Operation stage
Internal and external people training costs and maintenance costs
Cost treatment
Expense as there is no future incremental economic benefit
Similar considerations would arise in multiple staged deployments where each phase or module provided through the cloud would need to be separately assessed
Amortisation of capitalised costs – useful life
Capitalised initial costs should normally be amortised over the life of the service agreement on a straight line basis. The amortisation should not be based on prospects about the entity’s use of the software (for example, how many users access the software or volume of transactions in a given month).
The amortisation period may be extended beyond the non-cancellable period of the service to include:
Periods covered by an option to extend if the user is reasonably certain it will exercise that option, and
Periods covered by an option to terminate if the entity is reasonably certain it will not exercise that option.
The amortisation period assessment will need to be reassessed periodically, with any change accounted for prospectively as a change in estimate.
Next Steps
Accounting for cloud software arrangements is an area that requires decision. It is essentially a different economic model to traditional licence, acquisitions or hire purchase engagements, and the accounting may give rise to a different earnings, EBITDA and balance sheet outline. Where these have been used to support valuation models, businesses should keep shareholders informed by clearly communicating their shift to a cloud environment as part of a discussion on IT strategy.
For more information on cloud accounting, talk to Morshona Advisory team.
Comments