ASU 2015-05: Software License or Service Contract?

The Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2015-05 to clarify how a customer should account for fees paid in a cloud computing arrangement (CCA). Before this guidance, accounting for arrangements like software as a service (SaaS) was inconsistent, with some companies treating them as software purchases and others as service contracts. ASU 2015-05 provides a framework to determine if a CCA includes a software license or is solely a service contract, and this distinction dictates whether the costs are capitalized as an asset or expensed as they are incurred.

Identifying a Software License in a Cloud Arrangement

To determine if a cloud computing arrangement contains a software license, a company must evaluate two criteria, and both must be met. The analysis focuses on the customer’s rights and practical abilities concerning the underlying software, not the method of delivery. If the customer lacks the right to take possession without a major penalty, or if it is not feasible to run the software independently, the analysis stops and the arrangement is not considered a software license.

The first condition is that the customer has the contractual right to take possession of the software during the hosting period without a significant penalty. A significant penalty is an economic deterrent so large the customer would not realistically exercise its right, such as a large one-time payment or the forfeiture of a substantial asset.

The second condition is that it must be feasible for the customer to run the software on its own hardware or contract with a third party to host it. Feasibility means the customer can find another vendor or has the internal resources to manage the software. This condition is not met if the software is highly specialized and can only be operated by the vendor or is linked to the vendor’s proprietary hardware.

Accounting Treatment for Arrangements with a Software License

When a cloud computing arrangement includes a software license, the company must account for it like other internal-use software. The portion of the contract fee for the software license is recognized as an intangible asset on the balance sheet. The cost of this asset includes the license fee and certain implementation costs.

The process involves capitalizing specific costs incurred during the application development stage, governed by Accounting Standards Codification 350-40. Eligible costs include external direct costs of materials and services, fees paid to third parties for development, and payroll for employees directly involved in the project.

Once the software is ready for use, the capitalized costs are amortized, which is the systematic expense of the asset’s cost over its estimated useful life. Amortization is done on a straight-line basis, with the expense reported on the income statement within operating expenses.

Accounting Treatment for Arrangements as Service Contracts

If a cloud computing arrangement does not meet the criteria for a software license, it is accounted for as a service contract. The fees paid are recognized as an expense on a straight-line basis over the term of the hosting agreement as services are received. Unlike the software license model, no intangible asset is recognized on the balance sheet.

A later update, ASU 2018-15, clarified the treatment of implementation costs for service contracts. This guidance requires companies to capitalize these costs and then expense them over the term of the hosting arrangement, applying the same principles used for internal-use software.