Cloud computing is on the rise. Companies are increasingly investing in cloud-based software solutions. But how do you account for these? International Financial Reporting Standards (IFRS) do not contain specific guidance which lead to diversity in practice. This was recently resolved by the IFRS Interpretations Committee. Let's take a look at their decisions.
Is cloud-based software accounted for in the same way as traditional software licenses for on-premise solutions?
No, usually not. In a cloud computing arrangement, a customer pays a fee to a vendor in exchange for access to software over the internet. The software itself is hosted by the vendor on the vendor’s IT infrastructure. In our experience, most cloud computing arrangements only provide a service during the contract term. Hence, no software intangible asset can be recognized. Instead, the related expenditure is recognized during the contract term. If a company pays for such service in advance, then it recognizes a prepayment asset. Conversely, a company recognizes an accrued expense if it receives a service prior to paying for that service.
Only in limited circumstances does a company control cloud-based software and hence can recognize it as a software intangible asset. This requires the right to restrict the access of others – e.g. the software vendor and its other customers – to the economic benefits flowing from the software, or the right to obtain the benefits from the software without the software vendor’s hosting services. Indicators of such rights are e.g.:
- the right to take possession of the software and to run it on the company’s own or a third party’s IT infrastructure; or
- exclusive rights to use the software or ownership of the intellectual property for customized software – i.e. the vendor cannot make the software available to other customers.
How to account for the implementation costs of cloud-based software?
Cloud-based software ranges from simple application software to complex solutions like enterprise resource planning (ERP) systems. Complex solutions usually involve significant implementation costs, such as costs for testing, data migration and conversion, user training, configuration and customization of the cloud-based software. The accounting for these implementation costs depends on whether the cloud-based software classifies as a software intangible asset or a service contract.
For software intangible assets, the requirements of IAS 38 Intangible Assets apply. However, this is not the case for service contracts. For the latter the IFRS Interpretations Committee (IFRS IC) developed specific principles to determine the accounting for each individual implementation service (or cost). Questions to consider are:
- Who is performing the implementation service?
- Is the implementation service distinct from the access to the software?
- Does the expenditure give rise to a separate intangible asset under IAS 38?
Our cloud computing implementation costs talk book will help you apply these principles by providing a flow chart for analyzing these costs as well as further observations and illustrative examples.
Based on the principles developed by the IFRS IC, most implementation services are to be expensed immediately in practice. Depending on your previous accounting policy, this may result in significant changes.
By when do you need to apply the decisions made by the IFRS IC?
The IFRS IC issued two agenda decisions on cloud computing – one in March 2019 and one in March 2021. Agenda decisions provide further explanations about existing IFRS requirements. For this reason, a company might determine that it needs to change an existing accounting policy. The IASB as well as regulators expect companies to implement any required changes in a timely manner. In the context of cloud computing arrangements, this means that the new framework generally needs to be implemented in the financial statements for 2021. Therefore, it is time to act now!
How to account for any required changes?
If your existing accounting policy needs to be amended, this will trigger a change in accounting policy – i.e. you will need to apply the new rules retrospectively. Retrospective application requires adjusting the opening balance of equity for the earliest prior period presented and comparative amounts for each prior period presented as if the new accounting policy had always been applied.