Finance Friday

Is Your Company Accounting Correctly for Software from the Cloud?

As technology continues to advance, organizations are moving their software away from boxed solutions or internally developed software to hosted, cloud-based computing arrangements. SaaS, or software as a service, often reduces infrastructure requirements and can be customized based on a company’s evolving needs.

As companies access cloud-based software, they need to consider whether they are accounting for it correctly.

The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2018-15 to specifically address software accessed through a hosting arrangement, and align the treatment of certain related implementation costs with existing guidance for internal use software (ASC 350-40).  

The new guidance was effective for public companies for annual periods, including interim periods within those annual periods, beginning after December 15, 2019. For private entities, this ASU is effective for annual periods beginning after December 15, 2020, and interim periods in annual periods beginning after December 15, 2021. Early adoption is permitted.

How do I know if the new guidance applies to my company’s software arrangement?

The new guidance applies if an organization is accessing software for internal use (i.e., solely to meet the entity’s internal needs with no substantive plans for marketing the software externally) through a service contract obtained as part of a hosting arrangement that does NOT meet either of the following criteria in ASC 350-40-15-4A:

  • The customer has the contractual right to take possession of the software at any time during the hosting period without significant penalty; and
  • 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 both of these criteria are not met, the hosting arrangement is considered a service contract and does not constitute a purchase of, or convey a license to, software.

How are hosting arrangements accounted for under ASU 2018-15?

A company’s license, hosting, and related costs for a subscription to a hosting arrangement are recognized as an operating expense over the term the Company has access to the software and services. This has not changed from historical guidance. The expense is typically on a ratable basis over the stated term, unless another pattern of recognition more accurately reflects the consumption of benefits.

The updated guidance treats implementation costs in a hosting arrangement (implementation, setup and other upfront costs) as if they were internal-use computer software project costs under existing ASC 350-40 guidance. This provides a framework for companies to determine whether certain implementation, training or data conversion costs for cloud-based services contracts should be expensed as incurred, or capitalized and recognized over the term of the arrangement.

Applicable implementation costs should be capitalized and expensed over the term of the arrangement. They should be presented on the balance sheet in the same way as software subscription fees, such as prepaid expenses or other assets. The expense recognized as these costs are amortized should be reported in the same income statement line item as the subscription fees. In contrast to internally developed software, these costs would not be reflected as an identifiable intangible asset or component of property, plant and equipment.

The update also provides guidance for how these costs are reflected on the statement of cash flows.  Capitalized implementation costs for a hosted SaaS arrangement are considered operating activities, and the associated expense is a component of overall net income (loss). This is in contrast to internally developed software costs, for which the cash outlays are reported as investing activities, and the associated amortization would have been presented as an adjustment to reconcile net income (loss) to operating cash flows by backing out the effects of the amortization.

Which implementation costs can be capitalized, and how should the expense be recognized?

Using the framework for internally developed software, hosting arrangement implementation costs should only be capitalized in the application development stage. Any implementation costs incurred during the preliminary stage or post implementation / operating stage should be expensed as incurred.

It is important to note that administrative, overhead or training costs incurred during any stage should be expensed as incurred. Data conversion costs also cannot be capitalized. This means companies need to carefully review charges incurred internally or by third parties, evaluate different components and determine appropriate treatment.

The capitalized costs should be amortized over the term of the hosting arrangement. Any options to extend or terminate the arrangement should be evaluated when establishing the term as described in ASC 350-40-35-14. Amortization begins once the software is ready for its intended use and substantial testing of the software has been completed. Companies should periodically reassess the estimated term of the arrangement and account for any change in the estimated term as a change in accounting estimate.

How should companies evaluate the implementation costs for impairment?

If the hosting arrangement is not expected to provide substantive service or be used in the manner or extent as originally expected, the company should evaluate these capitalized costs to determine whether the carrying amount of the implementation costs is recoverable.  Recognition and measurement of impairment is done in the same manner as if it was a long-lived asset under ASC 360-10-35.

For more information about accounting for cloud-based software, contact us. We are here to help.

Finance Friday- Year End Tax Strategies through Charitable Gifts

My family and I are charitably inclined and give to our favorite charities every year.  This year, with all that has happened, we believe it is even more important to support the causes that align with our beliefs.  What is a potential way we can give while also taking advantage of the tax deductions available to us?

We all are aware of the challenges 2020 has posed around the globe.  Many people are asking how they can help, whether it is through volunteering their time or resources to help those in need.  One unique aspect of the pandemic, and the resulting CARES act, is that an individual can contribute cash directly to a charity and deduct up to 100% of AGI (adjusted gross income) instead of the normal 60% cap for cash contributions.  Another method that has increased in popularity over the last few years is a Donor Advised Fund.  A Donor Advised Fund or “DAF” is a turnkey solution that allows a person to consolidate all their charitable contributions from one account, while also giving the donor the ability to invest the funds in a customized investment strategy.  A great feature of a DAF is you do not have to make charitable grants in the same year as your DAF contribution.  This gives the original funds time to grow and make a larger impact at a later date. This added time (funds are invested in DAF, but not doled out to charity all at once) can leverage the amount of your ultimate contribution in years when investment performance has been positive.  

A DAF is also extremely flexible on what you can contribute.  You can contribute cash, securities, privately held business interests, and even restricted stock.  We have found that for many, appreciated securities are a great option because they can avoid capital gains tax while still being able to deduct the fair market value of the securities as a charitable donation.  We have even incorporated a DAF giving strategy with an executive’s 10b5-1 selling plan, allowing the donor to give shares of their company’s stock, while receiving a powerful tax deduction.  

Once you make the initial donation to the DAF, you can liquidate the securities and reinvest the proceeds in a customized investment strategy until the time you make a grant to the charity or charities of your choice.  Donor Advised Funds are also great for years where you would like to “lump” your charitable deductions.  In high income years, you can make a large DAF contribution and then let the assets grow tax free until you want to make specific grants to the causes of your choice.  

Donor Advised Funds are a powerful tool for anyone who is looking to make a difference.  They are simple yet effective in consolidating your charitable donations while also giving you the power to potentially grow that asset base over time.  As 2020 has reminded us, there are many in need around the world and a Donor Advised Fund is a great way to support charities while maximizing your impact.

Business Budgeting Considerations for 2021 and Beyond

Nobody saw 2020 coming when organizations put their budgets together in late 2019. As we enter the budgeting cycle for 2021, there is no clear picture of what the sustained new normal will hold. How do business owners confidently and competently approach budgeting with this level of uncertainty?

Forecast with Care and Stay Flexible

To echo the iconic business phrase from the book “Good to Great,” it’s important for leaders to firmly “embrace the brutal facts” of how the current economic situation has affected their business and to deeply consider what the continued impacts are likely to be. Companies generally approach annual budgeting with growth in mind, but current circumstances suggest a different approach: adopting a more flexible mindset while moving through the process and the year ahead.

Complicating the budget cycle this year is the difficulty of assessing what performance is going to look like over the next 12 months in such a dynamic environment. Some companies have seen an increase in business during the pandemic. Those that have not should identify areas in their budgets that provide flexibility to maneuver, should economic conditions bring additional unexpected negative impacts in the coming year.

For most companies, the hope each year is to meet or beat your budget. What additional planning is required due to the COVID-19 impact and ongoing uncertainty? What will this mean for the business? What actions can be taken if further impact occurs? These could be investment adjustments, hiring freezes or labor cuts, operational changes, and more. Every business leader needs to know what levers they can pull under potential impact scenarios.

Maintain a Strategic Mindset and Look for Past Patterns

Even in such a tumultuous environment, leaders should prepare their near-term budgets in the context of their broader long-term strategic vision. Ask the tough questions. Is it important to find a way to continue to invest in the company during this time? Should this be a save-at-all-costs period for the business until the economic picture is clarified? What will put the company in a position to take advantage of the recovery when it comes?

In all cases, leaders must ensure their balance sheet is as strong as possible and that they can weather the storm. Adopting an approach that is too conservative could limit an organization’s ability to take advantage of the economic rebound when it happens. Here’s how one organization looked at past patterns to inform their planning:

When COVID-19 began unfolding in the first quarter of 2020, “ABC Company” almost immediately experienced a 20% drop off in revenue from the previous year. At the same time, their staff demonstrated a range of reactions – everything from thinking that they were in imminent danger to others thinking the concerns were much ado about nothing. Leadership suspected that once they got through the initial wave of impacts that business would come back and that there would be opportunities they could take advantage of. They consulted with their external finance advisors to challenge and test that hypothesis.

Part of the planning involved looking at the company’s and market’s performance and response patterns throughout the 2008 downturn and subsequent recovery. Several similarities were identified, as were “apples to oranges” elements that were not applicable in the current situation. After comparing all the variables, ABC’s leaders concluded that they would recover sooner than many businesses would, even though they experienced significant impacts up front.

This informed ABC’s decision to not slow down hiring, but rather to start ramping up hiring in advance of the recovery they anticipated. They prepared a range of forecasts complete with if-then implications and actions that have ultimately put them in a stronger market position compared to others in their market.

Examine and Act on Leading Indicators

While leaders should continue to monitor their balance sheet and cash flow with great scrutiny, they should also remember that financial metrics are really lagging indicators. In periods of greater unpredictability, it’s even more important to keep a close watch on leading indicators that may suggest actions that will put the business in a stronger position. These leading indicators could include:

  • Sales lead volume and pipeline health
  • Inventory levels and integrity of supply chain
  • Average order value
  • Average contract/agreement lengths

Examining these and related KPIs will provide greater insight into the company’s health. In evaluating them, leaders should be careful to honestly assess what metrics appear to be temporary anomalies and which look to be predictive of near-term future conditions.

Control What Can Be Controlled

Business leaders should not expect to perfectly predict the broader ups and downs of the economy in 2021 and beyond. Even in unprecedented times such as these, leaders can look to the past for insights to help guide decisions. Most importantly, leaders should remain nimble, prepare for a wide range of possibilities, and stay vigilant in monitoring leading indicators to ensure they are moving in the right direction.

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Need help developing your own plan in this uncertain environment to put your business on a better path to success in 2021? Request a free consultation from a vcfo expert who can help you strengthen your planning process.

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