Cloud computing arrangements based on IFRS

In cloud computing arrangements, the customer does not have possession of the underlying software. Rather, the customer accesses and uses the software on an as-needed basis. Typically, the customer pays a fee to a vendor in exchange for access to software over the internet. Cloud computing arrangements are sometimes referred to Software as a Service (SaaS), Infrastructure as a Service (IaaS) or hosting arrangements.

Cloud computing arrangements continue to be an area of rapid development and this has resulted in significant changes in accounting policies. IFRS standards do not contain explicit guidance on how a customer should evaluate and account for cloud computing arrangements. The issue has been raised with the IFRS Interpretations Committee (IFRIC) which has then provided additional guidance on accounting by publishing agenda decisions.

This article provides an explanation about how an entity (customer) should evaluate whether the rights granted in a cloud computing arrangement create an intangible asset, a lease or a service contract. In addition to a fee for use of the software application, customer in a cloud computing arrangement often incur up-front costs to implement the software and the customer needs to assess whether the implementation service is distinct from the service of receiving access to the software. Moreover, the accounting for these implementation costs depends on whether the customer has a software asset or a service contract. Examples of implementation costs include testing, data migration and conversion, training, configuration of the software and customisation of the software.

Evaluation of applicable IFRS standards

An entity should evaluate whether the rights granted in a cloud computing arrangement are within the scope of IAS 38 Intangible assets or IFRS 16 Leases. Otherwise, the arrangement is likely to be a service contract.

As per IFRS 16, a contract is, or contains, a lease if it conveys the right to control the use of an identified asset for a period of time in exchange for a consideration. IFRS 16 further explains that the right to use an asset, throughout the period of use, is when a customer has both – the right to obtain substantially all the economic benefits from use of the identified asset and the right to direct the use of that asset. Cloud computing arrangements generally do not meet the definition of a lease under IFRS 16. This is because the right to receive future access to the supplier’s software does not in itself give the entity any decision-making rights about how and for what purposes the software is used. If a cloud computing arrangement does contain a lease, then an entity applies the provisions of IFRS 16.

An entity should evaluate whether a cloud computing arrangement includes a right to use tangible assets – for example, servers. If this is the case, the lease of the tangible asset will be accounted for separately under IFRS 16.

As per IAS 38, an intangible asset is ‘identifiable’ if it arises from contractual or other legal rights or if it is separable. In addition, an entity must control the intangible asset. In some limited circumstances, features of a cloud computing arrangement that may indicate that the entity obtains control of a software intangible asset include:

The right to take possession of the software and run it on the entity’s own or a third party’s own infrastructure, or
Exclusive rights to use the software or ownership of the intellectual property for customised software – i.e., the vendor cannot make the software available to other customers.

In our experience, cloud computing arrangements usually do not give rise to an intangible asset under IAS 38. This is because a right to receive future access to the supplier's software does not in itself give the entity the power to obtain the future economic benefits flowing from the software and to restrict others' access to those benefits.

If the cloud computing arrangement does not provide the customer with an intangible asset for the software, and does not contain a lease, then the right to access the software over the contract term in the future is a service contract.

The IFRS Interpretations Committee (IFRIC) agenda decisions

The IFRS Interpretations Committee (IFRIC) has published two agenda decisions in March 2019 and March 2021 that provide guidance on accounting for Software-as-a-Service (SaaS) arrangements.

The first agenda decision published in March 2019 considers whether a customer receives a software asset at the contract commencement date or a service over the contract term.

Fact pattern - An entity (customer) may enter into a contract under which it pays a fee in exchange for software services hosted by the supplier, commonly referred to as ‘software as a service’ arrangements or ‘cloud computing’ arrangements. The supplier’s software runs on cloud infrastructure managed and controlled by the supplier. The customer accesses the software on an as-needed basis over the internet or via a dedicated line. The contract does not convey to the customer any rights over tangible assets. At the contract commencement date, a question arises about whether the entity receives a software asset or a service over the contract term.

Conclusion – this agenda decision concludes that SaaS arrangements are likely to be service arrangements, rather than intangible or leased assets. This is because the customer typically only has a right to receive future access to the supplier’s software running on the supplier’s cloud infrastructure and therefore the supplier controls the intellectual property (IP) of the underlying software.

The second agenda decision, published in March 2021, deals with specific circumstances in relation to configuration and customisation costs incurred in implementing SaaS.

Fact pattern - A customer enters into a SaaS arrangement with a supplier. The contract conveys to the customer the right to receive access to the supplier’s application software over the contract term. That right to receive access does not provide the customer with a software asset and, therefore, the access to the software is a service that the customer receives over the contract term. The customer incurs cost of configuring or customising the supplier’s application software to which the customer receives access.

Configuration involves 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.

Customisation involves modifying the software code in the application or writing additional code. Customisation generally changes, or creates additional, functionalities within the software.

Analysis and Conclusion

In analysing the request, the IFRS Interpretations Committee considered the following questions:

Does the customer recognise an intangible asset under IAS 38 in relation to configuration or customisation of the application software.
If an intangible asset is not recognised, how the customer accounts for the configuration or customisation costs.

In the fact pattern, the supplier controls the application software to which the customer has access. The assessment of whether configuration or customisation of that software results in an intangible asset for the customer depends on the nature and output of the configuration or customisation performed. The Committee observed that, in this SaaS arrangement, the customer often would not recognise an intangible asset because it does not control the software being configured or customised and those configuration or customisation activities do not create a resource controlled by the customer that is separate from the software. However, in some circumstances, the arrangement may result in, for example additional code from which the customer has the power to obtain the future economic benefits and to restrict others’ access to those benefits. In that case, in determining whether to recognise the additional code as an intangible asset, the customer assesses whether the additional code is identifiable and meets the recognition criteria in IAS 38.

Accounting for configuration or customisation costs in a cloud service contract

The following framework is based on the principles in IFRIC agenda decision published in March 2021 to determine how to account for the configuration or customisation costs in a cloud service contract.

The configuration or customisation service may be performed by the cloud vendor, the entity’s internal personnel or a third party – e.g., a consulting company. When the cloud vendor performs these services in addition to providing access to the software, a question arises about how the customer identifies the services that it receives.

The IFRS Interpretations Committee discussed how a customer identifies the services that it receives from the cloud vendor (including cases in which the cloud vendor subcontracts services to a third party). The Committee noted that the requirements of IFRS 15 deal with similar and related issues to those faced by the customer; therefore, the customer assesses whether the configuration or customisation service is distinct from the access to the software or is part of the service of receiving access to the software.

In the context of cloud computing arrangements, if the customisation service requires the cloud vendor to significantly modify the software, then a customer might conclude that the promises to transfer the software and the customisation service are not distinct within the context of the contract. However, the conclusion could be different in a case when a cloud vendor provides configuration services which are not likely to significantly modify the software. So, the IFRS 15 guidance should be carefully analysed in each scenario.

If the implementation service provided by the cloud vendor is distinct from the access to the software, then it is not part of the service of receiving access to the software. Therefore, it is expensed when it is received – i.e., when the service is performed by the cloud vendor – unless it gives rise to a separate intangible asset. If the expenditure gives rise to a separate intangible asset, then it should be accounted for under the requirements of IAS 38 – capitalise and amortise.

Conversely, if the implementation service is not distinct from the access to the software, then the related expense is recognised over the period during which the supplier provides access to the software – i.e., it is part of the cost of the service of receiving access to the software. If an entity pays for this service of receiving access to the software in advance, then it recognises a prepayment asset.

This assessment is not necessary for configuration or customisation services performed internally or by a third party other than the cloud vendor because these services are generally distinct from the service of receiving access to the software provided by the cloud vendor. These services are capable of being distinct because they could be provided separately by a third party other than the cloud vendor or performed internally and are not integrated with the customer’s ability to derive its intended benefit from the software.

If a cloud arrangement includes multiple distinct services that are received over different periods, then a company may need to allocate the total consideration paid to each service – e.g., based on the relative standalone price of each service.

Conclusion

IFRIC agenda decisions provide explanatory information and are intended to provide additional guidance for the application and implementation of IFRS standards and companies need to consider them when applying the IFRS standards.

In recent times, our working world has become more innovative, digitalised and connected. This has led to an increase in the use of cloud computing arrangements. The analysis and determination of the appropriate accounting treatment could require significant judgement and often, also require a deep understanding of certain technical aspects of the arrangement.

In our view, these cloud computing arrangements are typically service contracts. These arrangements usually do not give rise to an intangible asset under IAS 38. Therefore, these costs are not capitalised as part of the cost of a software intangible asset but are expensed as incurred, i.e., when the service is received.

In some limited circumstances, software intangible asset is recognised in a cloud computing arrangement. A company may determine that it controls a software asset if it has the right to restrict the access of others – e.g., the software vendor and its other customers – to the economic benefits flowing from the software; or it can obtain the benefits from the software without the software vendor’s hosting services.

In the limited cases in which a customer controls a software intangible asset, the cost of that asset includes the directly attributable costs of preparing the software for its intended use. Under paragraph 28 of IAS 38, these costs include employee benefits and professional fees arising directly from bringing the software to its working condition, and costs to test whether the software functions properly. Consistent with a cloud service contract, implementation costs that give rise to an intangible asset under IAS 38 are capitalised. Therefore, many implementation costs such as testing, configuration and customisation of the software are capitalised because they form part of the cost of the software intangible asset.

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