Accounting for Fees Paid in a Cloud Computing Arrangement: Do You Meet the Criteria?

With recent advances in information technology has come significant growth in demand for cloud computing. Cloud computing is the delivery of on-demand computing resources, from applications to data centers, over the internet. Examples of cloud computing arrangements include software as a service, platform as a service, infrastructure as a service and other similar hosting arrangements.

Before the Financial Accounting Standards Board (FASB) issued the Accounting Standards Update (ASU) 2015-05 in April 2015, there was no guidance in generally accepted accounting principles (GAAP) explicitly addressing an entity’s accounting for fees paid in a cloud computing arrangement. ASU 2015-05, Intangibles — Goodwill and Other — Internal-Use Software (Subtopic 350-40) included information that provides entities with guidance on determining whether a cloud computing arrangement contains a software license that should be accounted for as an internal-use software license.

Under the new guidance, fees paid by a customer in a cloud computing arrangement are accounted for as internal-use software within the scope of FASB Accounting Standards Codification (ASC) 350-40, Internal-Use Software, only if the arrangement includes a software license. Under paragraph 350-40-15-4A, arrangements that include a software license must meet both of the following criteria:

1. The customer has the contractual right to take possession of the software at any time during the hosting period without significant penalty.
2. 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.

Paragraph 350-40-15-4B further defines the term without significant penalty to mean:

1. The ability to take delivery of the software without incurring significant cost.
2. The ability to use the software separately without a significant diminution in utility or value.

If an arrangement does not meet these criteria, and therefore does not include a software license, a customer accounts for the arrangement as a service contract, and therefore costs incurred are expensed over the term of the agreement.

The guidance does not specifically address the accounting treatment of other costs (i.e., implementation and other upfront costs) incurred by the customer when the software is accounted for as a service. Therefore, these costs should be analyzed carefully to consider the nature of the service received based on the agreement and determine the accounting treatment based on existing GAAP.

Effective Date
For public entities, the guidance is effective for annual periods, including interim periods within those annual periods, beginning after December 15, 2015. For all other entities, the guidance is effective for annual periods beginning after December 15, 2015, and interim periods in annual periods beginning after December 15, 2016. Early adoption is permitted.

Entities have the option to apply the guidance either prospectively to all arrangements they enter into or materially modify after the effective date, or retrospectively.

Depending on the method of transition elected, public entities are required to provide the disclosures indicated below:

Prospective Transition
Disclose the following in the first interim period and annual period after the effective date:

1. The nature of and reason for the change in accounting principle.
2. The transition method.
3. A qualitative description of the financial statement line items affected by the change.

Retrospective Transition
Disclose the following in the first interim period after the entity’s adoption date and in the interim periods within the first annual period:

1. The nature of and reason for the change in accounting principle.
2. The transition method.
3. A description of the prior-period information that has been retrospectively adjusted.
4. The effect of the change on income from continuing operations, net income (or other appropriate captions of changes in the applicable net assets or performance indicator), any other affected financial statement line item(s), and any affected per-share amounts for the current period and any prior periods, retrospectively adjusted.
5. The cumulative effect of the change on retained earnings or other components of equity or net assets in the statement of financial position as of the beginning of the earliest period presented.

All other entities are required to disclose the information above as well (depending on the transition method elected) in the first annual period after the entity’s adoption date, except that interim disclosures in the first annual period after the entity’s adoption date generally do not apply.