New accounting rules can bolster cloud’s appeal

March 26, 2020

A blog post by Akash Tayal, principal, Deloitte Consulting LLP, John Tweardy, principal, Deloitte Consulting LLP, Ganesh Moovera, senior manager, Deloitte Consulting LLP, Sean Torr, managing director, Deloitte Risk & Financial Advisory, Deloitte & Touche LLP and Chris Chiriatti, managing director, Audit & Assurance, Deloitte & Touche LLP

Many organizations around the globe have embraced cloud computing for benefits including agility, cost savings, and increased innovation. Until recently, however, accounting rules had not really caught up, offering little guidance to help companies allocate cloud costs between deferred and current-period operational expenses.

A new standard issued recently by the Financial Accounting Standards Board spells out the nuances in more detail—not only making such decisions more clear but frequently with the effect of making cloud transformation even more attractive.

Lighting the Way

Historically, accounting for software in general has been a challenge. Complex arrangements that combine service delivery with assets require significant analysis and judgment to determine how costs should be treated. Some might be recognized as the acquisition of an asset to be capitalized and amortized over time; others are treated as immediate expenses to be recognized as incurred through profit and loss. With the rise of cloud computing, it has been largely unclear how to account for implementation costs incurred in a hosting arrangement that is also a service contract, resulting in widely varying practices.

The new Accounting Standard Update 2018-15 aligns the accounting for implementation costs of cloud computing arrangements that are service contracts with existing accounting rules for internal-use software, including hosting arrangements that feature an internal-use software license. This gives organizations more specific guidance to help them determine which implementation costs should be immediately expensed through the income statement and which should be capitalized or otherwise deferred on the balance sheet and subsequently amortized.

Public US companies are required to comply beginning in their first interim reporting period in 2020; the deadline for private companies is 2021.

Aligning Cost Guidance

For most organizations undertaking a move to the cloud, the initial migration—typically a matter of either “lifting and shifting” applications over to the new platform or refactoring them for the purpose—has had to be expensed as a large initial cost. Typically, this directly affected the firm’s earnings before interest, taxes, depreciation, and amortization (EBITDA), potentially causing concern among CFOs and other stakeholders and sometimes factoring into decisions about whether and to what extent to adopt cloud technology.

Under the new standard, some of the costs involved in the migration phase can be deferred, making it possible to reduce the immediate impact on EBIDTA.

In addition to helping business leaders better plan and support cloud initiatives, there can be a personal side benefit for these executives, many of whom are evaluated and compensated according to EBITDA: By minimizing the immediate impact of cloud initiatives on that measure, the new rules could reduce some of the negative effect of cloud spending on their annual pay.

A Need for New Processes

To comply with the new rule, organizations will likely have to establish processes to distinguish cloud costs incurred during the preliminary and post-implementation stages from those incurred during application development, some of which must now be capitalized. That will mean tracking all cloud costs, maintaining careful records, and segmenting the costs for each activity—especially those that contribute to multiple project stages. Hybrid cloud implementations could complicate such assessments further.

Once cloud costs are organized, a more complex issue will be optimizing costs for the overall business. In general, the new accounting rule will increase the capitalization of certain cloud implementation costs, deferring them in a way that increases EBITDA during the implementation phase. Depending on the scale of the project, that could have a significant effect on companies considering cloud deployments.

As organizations continue to pursue the benefits of cloud transformation, CIOs can work with CFOs and other business leaders to devise an approach that aligns cloud strategy with long-term financial goals. With some careful cost accounting, cloud technology can deliver a better ROI than ever before.

This article first appeared on the WSJ.