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Accounting Standards Update: Internal-Use Software

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By   Lindsay Skinner

February 22, 2017

An Accounting Standards Update (ASU) provides guidance about how to account for costs incurred in a cloud computing or hosting arrangement. In April 2015, the Financial Accounting Standards Board (FASB) issued ASU 2015-05, Intangibles – Goodwill and Other – Internal-Use Software (Subtopic 350-40): Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement. The ASU is effective for fiscal years beginning after Dec. 15, 2015, for all entities, including interim periods within those annual periods for public business entities. An entity can elect to adopt the amendments either retrospectively or prospectively to all agreements entered into or materially modified after the effective date. Early adoption is permitted.

Summary Provisions of the Update
The ASU provides clarified guidance on how to account for licensing of software products when the software resides on the vendor’s or a third party’s hardware and is accessed on an as-needed basis via the Internet or a dedicated line defined as a “hosting arrangement.” Specific criteria were established to determine if a hosting arrangement includes the sale of a software license or just a service contract.

Specifically, a hosting arrangement is considered to include the sale of a software license only if both of the following criteria are met:

  • The customer has the contractual right to take possession of the software at any time during the hosting period “without significant penalty.” The term “without significant penalty” should consider the ability to take delivery of the software without incurring significant cost and the ability to use the software separately without a significant diminution in utility or value.
  • 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 these criteria are not met, the hosting arrangement is considered a service contract and separate accounting (capitalization) of a license is not permitted, rather costs incurred are required to be expensed over the term of the agreement.

When these criteria are met, the portion of the agreement relating to the purchase of a software license may be capitalized, consistent with the acquisition of other software licenses. Costs incurred will be allocated between the license and the hosting elements based upon the relative fair value of each element.

The guidance does not specifically address how costs incurred in connection with a hosting arrangement, for example, implementation and other upfront costs, should be accounted for. Accordingly, these costs should be analyzed to consider the nature of the service provided and determine the accounting based on existing general accepted accounting principles.

Key Considerations for Health Care Organizations
Many health care organizations are entering into arrangements that provide for the utilization and hosting of software for electronic health records, billing, general ledger and other systems. These contracts often include significant upfront implementation costs which may have previously been capitalized and, as a result of the guidance, portions or all of these costs may now be expensed as incurred. Health care organizations should review the terms of their cloud computing agreements and hosting arrangements entered into or modified after the effective date of the ASU and consider any potential financial reporting implications. Careful consideration should be made to understand and define services received during implementation in order to be recognized in the appropriate period regardless of whether a software license exists.

Implementation Examples
A hospital has entered a hosting arrangement with a vendor for their electronic health records (EHR) system. The hospital will have access to software licenses and monthly maintenance support from the vendor for the five-year term of the agreement. The EHR system will be hosted on the vendor’s servers. Management has reviewed the agreement and determined that it does not include the sale of a software license. Below is a breakdown of the costs associated with the agreement and the related accounting treatment. This example assumes all costs aside from the monthly usage fee are paid upfront during the implementation phase.

ASU Internal Use Software 1

Using the same example as above, it is now assumed that management has determined the agreement contains the purchase of a software license. In this situation, the costs assigned to the different categories, including software and equipment, are based on the relative fair value of each item in relation to the total cost incurred. The accounting treatment would be as follows:

ASU Internal Use Software 2