Accountants and CFOs have had their work cut out for them when trying to balance the checkbooks on cloud computing services. Because software and hardware is often categorized as an asset with depreciation, the proliferation of cloud — a subscription-based computing service rather than a capital expense — threw a wrench into traditional accounting for the IT department.
The Financial Accounting Standards Board (FASB), which provides guidance and sets accounting standards for public companies as directed by the SEC, set out suggestions for handling cloud computing in 2015. They recently convened to fix some of the problems created by this previous ordinance.
Here’s why cloud computing can cause headaches for your CFO and why the new FASB rules could help clear things up.
When enterprises first started looking towards the cloud as primary IT infrastructure, it had ripple effects on budgets and bonuses for management. Much of the time executives are judged based on EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization). When your IT infrastructure is almost entirely capitalized versus expensed, there is no impact to EBITDA, so it doesn’t affect any bonuses or metrics based on EBITDA.
Meanwhile, companies used depreciation to account for overall lifespan of a computing resource. For a server that cost $3,000 and was expected to run in production for three years, it would be accounted for as $1,000 in cost each year and tallied as such on the P&L within year.
Cloud services, on the other hand, are considered operational expenses (OpEx). We go on about this a lot, because it allows more flexibility from a budget planning perspective. However, it also reduces EBITDA.
So suddenly, these IT service contracts are cutting into EBITDA, as they are factored into those operational expenses rather than being used as a depreciating asset.
Back in late 2015, the FASB released guidance around cloud computing that distinguished between services that did or did not include software licensing. It is considered a service contract if there is no licensing involved. Under a service contract, companies are directed to guidance on internal-use software to determine which implementation costs to recognize as assets. However, the guidance does not address whether companies under such a service contract should capitalize or expense costs such as implementation and set-up.
This became a pretty big problem for some organizations, who were now no longer able to capitalize (depreciate) those costs, which can run into the millions for large scale cloud deployments. Instead of being able to amortize the cost over the length of the contract, they became a one-time hit on an annual budget.
Contracts with software, however, were classified as intangible assets, which are also amortized over the course of years.
Some costs may be capitalized even when the cloud service is considered a service contract, such as capital expenses related to improving or changing existing infrastructure or internal use software in order for it to work in conjuction with the new services. The customer may also amortize prepaid costs associated with the service contract.
Related costs to setup and implementation such as employee training and data migration or conversions are generally expensed (recorded immediately rather than capitalized/depreciated). As mentioned above, this can be a significant and immediate cost.
The FASB recently reconvened and discussed how to account for these implementation, setup, training, and other associated upfront costs when engaging in a cloud computing contract. While the new guidelines are still proposed and yet to be released, it appears that the recommendation will be to use existing guidance on internal use software to decide which costs are considered assets, with those costs that are considered assets to be amortized over the term of the hosting arrangement, allowing organizations to spread out those upfront costs over the noncancellable term of the contract.
Hopefully this change will help large enterprises better budget for cloud service contracts while also clearing up some confusion for the Head of Accounting.
Jason Graf is the VP of Finance at Green House Data.