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Accounting for the rise of cloud computing arrangements

Jan 12, 2024

Many financial institutions have found that their core accounting software providers are moving accounting systems to the cloud, following the trend of other software programs. While this cloud migration can help institutions transform the way they use data and give them access to innovative tools, it also comes with additional accounting concerns.

Cloud computing arrangements (CCAs) include software-as-a-service arrangements and related services (e.g., platform as a service, infrastructure as a service, etc.) These are also referred to as “hosting” arrangements in which the end user does not take possession of the software; instead, the software resides on the vendor’s or a third party’s hardware, and the institution accesses the software remotely.

Understanding the requirements for CCA accounting can help your financial institution prepare for both the latest digital tools and your next financial audit.

Accounting for software licenses within CCAs

CCAs may include a traditional license to the software in addition to other services. A CCA includes a software license if both of the following are true:

  • Your institution has the contractual right to take possession of the software at any time during the hosting period without significant penalty (i.e., the monetary or nonmonetary penalty is sufficiently significant to disincentivize your institution from taking possession of the software).
  • It is feasible for your institution to either run the software on its own hardware or contract with a third party unrelated to the vendor to host the software.

A software license within a CCA should be accounted for as an asset. To the extent any or all of the software license fees are still outstanding, a liability is recognized on the acquisition date of the license. For example, if a CCA requires 36 monthly installments of $10,000 for the software license, the institution will likely recognize an asset and liability for $360,000. No liability would be recognized if the institution pays the $360,000 up front for the license.

Accounting for hosting arrangements

If a hosting arrangement, or a portion of it, does not meet the software license criteria mentioned above, it is considered a service contract. 

With service contracts, it’s essential to understand the different project stages and when costs should be capitalized or expensed.

Capitalizing costs 

Accounting for implementation costs of the service contract is within the scope of ASC 350-40, Internal-Use Software. The accounting is determined by which stage of the project the costs are incurred:

1. Preliminary project stage

During the preliminary project stage, institutions are likely to do the following:

  • Make strategic decisions to allocate resources between alternative projects at a given time. For example, should programmers develop a new payroll system or direct their efforts toward correcting existing problems in an operating payroll system?
  • Determine the performance requirements (that is, what they need the software to do) and systems requirements for the computer software project it has proposed to undertake.
  • Invite vendors to demonstrate how their software will fulfill an institution’s needs.
  • Explore alternative means of achieving specified performance requirements. For example, should an institution make or buy the software? Should the software run on a mainframe or a client-server system?
  • Determine that the technology needed to achieve performance requirements exists.
  • Select a vendor if an institution chooses to obtain software.
  • Select a consultant to assist in the development or installation of the software.

Costs incurred within the preliminary project stage should be expensed.

2. Application development stage

Certain costs incurred during the application development stage can be capitalized. Examples include but are not limited to:

  • Integration (developing interfaces between the hosted software and your institution’s other systems)
  • Customization of your institution’s other systems and the hosted software
  • Configuration, either of your institution’s other systems or of the hosted software
  • Installation
  • Architecture and design
  • Coding
  • Testing 

Only the following costs of developing or obtaining internal-use software should be capitalized:

  • External direct costs of materials and services consumed in developing or obtaining internal-use computer software. These costs can include fees paid to third parties for services provided to develop the software, costs incurred to obtain computer software from third parties and travel expenses incurred by employees for 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 ASC 835-20.

3. Post-implementation stage

Capitalization of costs ends when a software project is deemed substantially completed and ready for its intended use. Software is ready for its intended use after all substantial testing is completed, which may occur before the software is placed in service.

Specific costs incurred that are prohibited from being capitalized and should be expensed are:

  • Training costs
  • Data conversion costs. This includes purging or cleansing existing data, reconciliation or balancing old data and the data in the new system, creation of new or additional data, and conversion of old data to the new system. One exception does apply if costs are incurred to develop or obtain software that allows for access to or conversion of old data by new systems. These specific costs may be capitalized.
  • General and administrative costs and overhead costs

Generally, once the software has gone live, the institution will enter the post-implementation operation stage. Costs incurred during this stage, for example, additional training and maintenance costs, should be expensed.

Amortizing costs

Implementation costs that are capitalized should be amortized over the term of the contract. This is defined as the fixed noncancelable term plus:

  • Options to extend the arrangement (if reasonably certain to exercise)
  • Options to terminate (if reasonably certain not to exercise that option)
  • Options to extend (or not terminate) the arrangement that are controlled by the vendor

Your institution should periodically assess the estimated term and adjust the amount of amortization if necessary.

Financial statement presentation

Amortization of capitalized implementation costs for CCAs should be reported in the statement of income in the same line item as the expense for fees for the hosting arrangement.

Capitalized implementation costs should be presented in the balance sheet in the same line item that a prepayment of the fees for the hosting arrangement would be presented. Cash flows from capitalized implementation costs are presented in the same manner as cash flows for the hosting arrangement fees.

How Wipfli can help

Whether you’re working with a cloud computing arrangement for the first time or need support for an existing arrangement, Wipfli can help. We take a customized approach to meeting your financial institution’s unique audit and accounting needs, applying our extensive industry experience to enhancing your organization. Contact us today to learn how we can help you get more from your audit and accounting.

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Brett D. Schwantes, CPA
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