Richard Howard and Ryan Mathers share their insights on the cloudy topic of accounting for software-as-a-service costs.
Accounting for software costs has traditionally lagged behind technological developments, so it is little wonder that there is some uncertainty around accounting for cloud computing costs. A recent International Financial Reporting Standards Interpretations Committee (IFRIC) agenda decision on cloud computing costs, while employing a sound decision-making framework, gave an answer at odds with the perception of many financial statement preparers.
Before IFRS, we had FRSs, and FRS 10 set out that software that made a computer productive was classed as a fixed asset. Software was viewed as an integral part of the hardware. This standard was introduced in 1997, when software was only beginning to become a differentiated product from the computer or server it sat on. Even at this early stage, accounting standards lagged what was happening in practice.
We have recently seen the move to cloud computing and software-as-a-service (SaaS). To illustrate the importance of cloud-based expenditure to the global economy, a Gartner survey from October 2021 estimated global IT expenditure of $4.47 trillion. Hardware constituted 18% of this spend, with the remainder spent on software, communications and data centres. Most of that will be spent on implementation and ongoing services for cloud-based software, cloud-hosted data, infrastructure as a service, and platforms.
We have seen two recent IFRIC decisions on the topic of SaaS. The first agenda decision, published in March 2019, concludes that SaaS arrangements are likely to be service arrangements rather than intangible or leased assets. This is because the customer typically only has a right to receive future access to the supplier’s software running on the supplier’s cloud infrastructure. Therefore, the supplier controls the intellectual property (IP) of the underlying software code. On its own, many would see this as a logical conclusion.
The second agenda decision, published in April 2021, deals with specific circumstances concerning configuration and customisation costs incurred in implementing SaaS. In limited circumstances, certain configuration and customisation activities undertaken in implementing SaaS arrangements may give rise to a separate asset where the customer controls the IP of the underlying software code. For example, the development of bridging modules to existing on-premises systems or bespoke additional software capability. In all other instances, the IFRIC agenda decision is that configuration and customisation costs will be an operating expense. Accordingly, they are generally recognised in profit or loss as the customisation and configuration services are performed or, in certain circumstances, over the SaaS contract term when access to the cloud application software is provided.
The March 2019 decision largely endorsed what was general practice. Companies were receiving a service over a period, and companies agreed with the substance of that.
The April 2021 decision, however, has been heavily debated. In discussions with many preparers of financial statements, few have agreed with the decision. While CEOs are talking about their digital transformation, this IFRIC decision tells the CFO how to account for the up-front configuration and customisation of that digital transformation, which in most cases is to expense it as incurred. This is at odds with a simple view expressed by many that the benefit of these costs accrue over a period, so why would they not be capitalised?
The April 2021 decision, however, is based on various principles that, in aggregate, gives a decision at odds with the view of many CFOs. To understand their decision, it is helpful to summarise the difference between on-premise software and software as a service (see Table 1).
In March 2019, IFRIC observed that a right to receive future access to the supplier’s software running on the supplier’s cloud infrastructure does not, in itself, give the customer any decision-making rights about how and for what purpose the software is used. Nor does it, at the contract commencement date, give the customer power to obtain the future economic benefits from the software itself and restrict others’ access to those benefits. Consequently, IFRIC concluded that a contract that conveys to the customer only the right to receive access to the supplier’s application software in the future is neither a software lease nor an intangible software asset, but rather a service the customer receives over the contract term.
Some scenarios were set out where the SaaS expenditure may meet the criteria for being an intangible asset, including where the customer is allowed to take ownership of the asset during the contract or where the customer is allowed to run the software on their own hardware (consistent with FRS 10 in 1997!)
The April 2021 decision led on from this train of thought, which can be summarised as: “If you incur expenditure connecting your business to a cloud-based solution, you do not own that asset. As it is not your asset, you cannot capitalise costs you incurred in customising or configuring that software.”
So, the question arises: are there any scenarios where an entity may capitalise configuration and customisation services? The simple answer is yes, and this occurs when the entity can control the software. For example, this may arise where the customer has the right to keep the software on-premise on their own servers or behind their own firewall. For on-premise software, the activities likely represent the transfer of an asset that the entity controls because it enhances, improves, or customises an existing on-premise software asset of the entity.
While IFRIC only discussed configuration and customisation activities of implementing a SaaS arrangement, the full SaaS implementation includes various activities. Table 2 illustrates some examples (not all-inclusive) of typical costs incurred in SaaS arrangements and the likely accounting treatment of each.
Practical implications
Beyond complying with IFRIC’s meeting agenda decision, there are some considerations for the many companies who have undertaken, or are undertaking, SaaS implementation projects:
- IAS 8 requires an entity to retrospectively apply an accounting policy change as if the entity had always applied the new policy. Companies may need to determine if they have capitalised costs that IFRIC may suggest should not have been capitalised and if this impacts comparative periods.
- Budgetary decisions may have been made based on digital transformation projects being largely capital in nature. However, with such costs now being expenses, it may impact performance when reviewed against budget or external forecasts.
- Some banking covenants contain EBITA or capital expenditure requirements, so the impact on covenant compliance may need to be assessed.
Conclusion
Interestingly, while the IFRIC Committee agreed with the interpretation from April 2021, out of the 19 comment letters received, only five respondents agreed with the analysis and conclusion. This would suggest that many see an issue with practicality in the decision.
Many companies we have spoken to point to the long-term benefit of such costs as the reason they view capitalisation as the appropriate route for configuring and customising software. Others have cited that it is an upgrade on the previously on-premise capitalised costs, hence appropriate to capitalise.
As we continue to use assets such as SaaS or other cloud-based solutions, it will be interesting to see how GAAP develops to recognise that software and hardware are no longer interdependent. Other topics such as accounting for open-source software development, open network cooperation, and platform arrangements will be interesting when they become material in the business world.
Richard Howard is a Partner in Deloitte’s Technology, Media and Telecommunications industry group.
Ryan Mathers is a Manager in Deloitte’s Technology, Media and Telecommunications industry group.
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