Happy New Year from all of us at the SEC Institute Division at PLI! We hope your new year is beginning well and if you are working on closing year-end December 31, 2015 that all is proceeding smoothly.
Last week, on January 7, 2016, Carol and George (that being us of course, the bloggers you are reading now!) presented a One-Hour Briefing, “PLI’s Second Annual Form 10-K Tune-up”. In the briefing we discussed three broad groups of issues to think about this year-end. These were New and Emerging Issues, Recurring Issues, and SEC Staff Focus Areas. Here is the complete list of the topics we discussed in the One-Hour Briefing:
- New and Emerging Issues
- Customer accounting for fees paid for cloud computing arrangements
- PCAOB AS 18 Related Parties – impacts both auditors & registrants
- PCAOB AS 17 Auditing Supplemental Info Accompanying Audited F/S
- Audit Committee disclosure
- ICFR and COSO
- Recurring Issues
- SAB 74 disclosures for Revenue Recognition and others
- Disclosure effectiveness
- Conflict minerals & Form SD disclosure
- SEC Staff Focus Areas
- Segments – focus on ASU 280
- Statement of Cash Flows
- Income taxes
- Fair value
- Foreign Exchange Rates, Commodity Prices, and Interest Rates
You can hear everything we discussed in an On-Demand version of the Briefing that will be available soon.
To augment the Briefing we are writing a series of blog posts to dive more deeply into each of the areas we discussed than the one-hour time limit allowed.
The first issue, customer accounting for fees paid for cloud computing arrangements, relates to ASU 2015-5. This ASU is effective for public business entities for periods beginning after December 15, 2015. For other entities the effective date is one year later.
One of the major issues in this new standard is that costs associated with a contract may be accounted for differently depending on whether the contract involves a software license or is only a service contract.
To get to that issue we need to review the major provisions of the ASU.
This project arose with the increase in the use of “cloud” based computing systems. These generally include “software as a service agreements” (SaaS) and other types of “software hosting” arrangements. There was no clear guidance about how customers should account for such arrangements. As a consequence, it was unclear whether these were software contracts subject to software accounting guidance or simply service contracts or perhaps a hybrid of the two accounting areas.
The ASU puts paragraph 350-40-15-4A into the ASC section dealing with internal use software:
“The guidance in this Subtopic applies only to internal-use software that a customer obtains access to in a hosting arrangement if both of the following criteria are met:
- The customer has the contractual right to take possession of the software at any time during the hosting period without significant penalty.
- It is feasible for the customer to either run the software on its own hardware or contract with another party unrelated to the vendor to host the software.”
If the above criteria are not met then the contract does not involve a software license and is a service contact.
The key issue here is that if the two criteria are met, then the agreement is treated as a multiple element arrangement and the costs are allocated between the software license and a service element associated with the hosting contract. The costs associated with the software license fall into the guidance for costs related to internal use software, or if appropriate, another software model such as software to be used in research and development.
On the other hand, if there is no software license element, then the contract is treated as any other service contract.
The financial reporting implications of this distinction can affect issues such as balance sheet classification, since a software license would be accounted for as an asset in appropriate circumstances, i.e. if it was paid for in advance. Income statement geography can also be affected as software amortization versus service contract expense could be in different income statement line items. And, it is possible that the amount of costs recognized in each period could be different.
This perhaps more complex issue depends on whether the arrangement includes a software license. If it does include a software license the internal use software guidance applies. The expense recognition part of this guidance is articulated in ASC 350-40-30:
30-1 Costs of computer software developed or obtained for internal use that shall be capitalized include only the following:
- External direct costs of materials and services consumed in developing or obtaining internal-use computer software. Examples of those costs include but are not limited to the following:
- Fees paid to third parties for services provided to develop the software during the application development stage
- Costs incurred to obtain computer software from third parties
- Travel expenses incurred by employees in their duties directly associated with developing software.
- Payroll and payroll-related costs (for example, costs of employee benefits) for employees who are directly associated with and who devote time to the internal-use computer software project, to the extent of the time spent directly on the project. Examples of employee activities include but are not limited to coding and testing during the application development stage.
- Interest costs incurred while developing internal-use computer software. Interest shall be capitalized in accordance with the provisions of Subtopic 835-20.
These costs can even include the costs of data conversion.
For service contracts, there is no such guidance. And here in fact lies the more problematic issue. If a cloud based computing arrangement includes a software license the internal use software guidance for costs may require capitalization of costs that would not be capitalized if the contract is only a service contract. Thus the amount of expense recognized for an arrangement could be different if it has a software license or does not have a software license. If you have this situation, careful analysis is crucial!
As always, your thoughts and comments are welcome!