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!
2 thoughts on “10-K Tip Number One for 2016”
Have any Big-4 firms weighed in on this? If so, what do they say?
Excellent question! Here is an excerpt from the Basis for Conclusions section of
BC7. The Board observed in redeliberations that some stakeholders wanted the scope of this Update to be expanded to address a customer’s accounting for implementation, set up, and other upfront costs that often are incurred by customers entering into cloud computing arrangements. The activities that entities perform in conjunction with entering into a cloud computing arrangement include training, creating or installing an interface, reconfiguring existing systems, and capturing and reformatting data. The Board observed that to the extent a cloud computing arrangement transfers a software license, Subtopic 350-40 provides guidance on how to account for costs such as those resulting from training, data capture, and conversion activities. In deciding not to provide additional guidance on the accounting for upfront costs incurred by customers entering into cloud computing arrangements that do not transfer a software license to a customer, the Board noted that initial costs incurred in service arrangements are not unique to cloud computing arrangements. Consequently, the scope of that issue is much broader than the scope of this Update. The Board decided that the scope of this Update should not be expanded to address the range of implementation and set- up costs incurred by a customer in a cloud computing arrangement.
As you would expect, when the FASB has said they are not going to render any kind of guidance for a particular issue, in general none of the large or small accounting firms are going to say, “here is the answer”. This is one of those judgment areas, and as usually happens when we all have to go back to principles and use judgment, we can likely expect some “diversity in practice”.
In fact, here is an excerpt from GOOGLE’s comment letter on the exposure draft for the ASU:
However, we observe that the Proposed Standard does not address the accounting treatment for implementation costs relating to cloud computing arrangements. We encourage the FASB to consider issuing explicit guidance with respect to the accounting treatment of implementation costs, as these costs can be significant. In our experience, the lack of explicit guidance for such costs currently results in diversity in practice. …..Specifically, where the arrangement contains a license, implementation costs would be capitalized, and where the arrangement is accounted for as a service contract, implementation costs would be expensed. We believe that in many cases, expensing such costs as incurred does not reflect the economics of the arrangement, and may provide a disincentive to enter into cloud computing arrangements.
The firms have recognized and alerted clients to the issue.
If you review the firm publications about this issue, they all basically say we will need to use judgment, and likely we will not all end up in the same place. Here is an excerpt from one firm:
There is limited guidance today on how to account for fees paid for a service arrangement. The upfront payment for a CCA contract may represent a prepaid asset to be recognized as expense over the CCA service contractual period. Other costs or fees paid to third parties other than the vendor should generally be expensed as incurred unless they represent a prepayment for services to be performed over a period of time.
Ah, diversity in practice!