Accounting Alert

This Accounting Alert is issued to circulate International Financial Reporting Standards (IFRS) Viewpoint on treatment and accounting configuration or customization costs in a cloud computing arrangement.

Overview

The International Financial Reporting Interpretations Committee (IFRIC) received a request addressing how a customer should account for costs of configuring or customizing a supplier’s application software in a Cloud Computing or Software as a Service (SaaS) arrangement. Significant diversity in practice had developed and the IFRIC determined it was appropriate for an agenda decision to be issued.

The IFRIC determined sufficient guidance exists within the relevant accounting standards and therefore no amendments to accounting standards were required. The rationale for arriving at this conclusion, which forms part of the interpretation of IFRS, is set out in the agenda decision.

Cloud Computing

Cloud computing is a confusing term that can be interpreted in a variety of ways, with differing consequences.  Generally, computing arrangements can be broken into three broad categories:

1. Licensed software on premise
2. Licensed software off premise
3. Software as a service

In the first two categories, a license to use the software as the purchaser sees fit is typically granted. This includes an ability to choose where and how the software operates, and whether it operates at all. In the first category, the software operates in environments owned and operated by the entity acquiring the license – for instance, a local operating system on a desktop computer. In the second category, the purchaser has chosen (but not been forced) to operate the software in a third party’s environment. This may be selected to operate an ERP or other business critical platform on the basis of guaranteed uptime, distributed backups, and guarantees of otherwise unavailable levels of data security.

In the third category – widely described as SaaS (software as a service) – the purchaser has been granted a right to access software and use it for its purposes. No right to transfer the software to another platform or to control the method of operation of the software is granted beyond what is contractually agreed.

Diversity in Practice

The IFRIC identified various approaches to customization and configuration costs for cloud computing arrangements were utilized by companies depending on internal policy. These policies varied from expensing all costs in full to capitalization of all costs in full, with most entities taking a more nuanced approach in their capitalization policy and differentiating between expenditure with different underlying fact patterns.

The IFRIC determined a nuanced approach indicating IAS 38, Intangible Assets, was appropriate depending on the facts and circumstances of the projects undertaken and the rights and obligations of the entity as it relates to the individual elements of the projects. Many entities will find their historic policies, though nuanced, will not conform to the principles as described by the IFRIC.

Agenda Decision Requirement

The agenda decision requires management to capitalize those elements of expenditure that meet the definition of an intangible asset as defined by IAS 38 and recognize any additional amounts as an expense as the entity benefits from the expenditure – either by applying IAS 38 or applying another accounting standard.

The agenda decision clarified:

• the nature of expenditure that met the definition of an intangible asset;
• the methods of differentiating between intangible assets and expenses; and,
• the pattern in which the entity benefits from expenditure that does not qualify as an intangible asset.

Intangible Assets vs. Expense

The IFRIC identified the disparity in practice was caused in part by confusion over the definition of an intangible asset and whether costs incurred met the criteria to be recognized as an intangible asset.

To assist with this confusion, the IFRIC identified two general ‘buckets’ of implementation cost incurred in a cloud computing arrangement:

1. configuration costs, and
2. customization costs.

Configuration costs were defined as ‘involving the setting of various ‘flags’ or ‘switches’ within the application software, or defining values or parameters, to set up the software’s existing code to function in a specified way’. Customization was defined as ‘involving modifying the software code in the application or writing additional code. Customization generally changes, or creates additional, functionalities within the software.’ 

An intangible asset is recognizable when it has the following characteristics:

• the asset is separable and transferable from the entity, or arises from contractual or other legal rights;
• the asset is a resource controlled by the entity; and,
• the entity has the power to obtain economic benefits flowing from the resource and restrict the access of others to those benefits.

From the above, the IFRIC communicated it is typical the software underlying a cloud computing arrangement is not transferred to a customer, and the setting of flags (i.e., configuration) in third party software does not provide a separable and transferable, or contractual, right to an asset as no asset that is separate from the software has been created.

Error or Change in Policy?

The IFRIC has identified disparity in practice exists and has issued an agenda decision on the basis of clarifying which policies are acceptable. In our view, it is appropriate in this instance to consider the correction of any related recognition and measurement arising from the application of the agenda decision as a change in accounting policy as opposed to a restatement due to an error.

While the form of restatement of prior periods is similar, it is appropriate in this instance to refer to a change in policy as a result of the IFRIC agenda decision as opposed to a restatement due to a prior period error.

In the instance of a change in policy, the appropriate disclosures are described in IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors, and include:

• the nature and change in accounting policy;
• the reasons why applying the new accounting policy provides reliable and more relevant information;
• for the current period and each prior period presented, to the extent practicable, the amount of the adjustment:
  • for each financial statement line item affected, and
  • if IAS 33, Earnings per Share,applies to the entity, for basic and diluted earnings per share
  • the amount of the adjustment relating to periods before those presented, to the extent practicable; and,
• if retrospective application is impracticable for a particular prior period, or for periods before those presented, the circumstances that led to the existence of that condition and a description of how and from when the change in accounting policy has been applied.

When Should the Policy be Implemented?

For certain entities, the adoption of the new policy will result in minimal impact as a result of known limitations in the volume of contracts within the scope of the IFRIC agenda decision.

For other entities, the impact will be broader and may require significant projects to be undertaken to obtain, collate, and make judgements on the underlying information. It is therefore generally accepted the agenda decision may require effort to determine the impact of the agenda decision and adjust the financial statements of an entity; it may also be appropriate for entities to expedite the adoption of a revised policy in response to the agenda decision.

A general expectation has been communicated that all entities will have adopted the new policy by December 31,  2021. We do note, however,  that accuracy is paramount. While an entity should seek to expedite adoption,  corporate governance will require appropriate controls to be implemented to ensure accuracy in adoption which may require a more deliberate approach to ensure material accuracy.

Our view is the adoption of an accounting policy is governed by IAS 8 which does not allow for an ‘incomplete’ adoption of a policy. Any adoption should be completed in a single step and not involve restatement over multiple periods.

The viewpoint also discussed important matters such as when intangible assets most likely be created, the pattern of benefit where intangible asset does not exist, definition of distinct service arrangements, and transactions with elements of both intangible asset and expense.  The viewpoint also provided additional considerations such as disclosures for changes in policy, and practical applications. 

See attached IFRS Viewpoint for further details.