Issue Summary No. 1, Supplement No 1 * MEMO Issue Date September 28, Memo No. Thomas Faineteau EITF Coordinator (203)

Transcription

1 Memo No. Issue Summary No. 1, Supplement No 1 * MEMO Issue Date September 28, 2017 Meeting Date(s) EITF October 12, 2017 Contact(s) Project Project Stage Date previously discussed by EITF Previously distributed Memo Number Jaime Dordik Assistant Project Manager / Coauthor (203) Thomas Faineteau EITF Coordinator (203) John Schomburger Postgraduate Technical Assistant (203) Cullen Walsh Assistant Director (203) Jason Bond Practice Fellow (203) Robert Uhl EITF Liaison (203) Issue No. 17-A, Customer s Accounting for Implementation, Setup, and Other Upfront Costs (Implementation Costs) Incurred in a Cloud Computing Arrangement That Is Considered a Service Contract Initial Deliberations July 20, 2017 Issue Summary No. 1, dated July 7, 2017 Memo Purpose 1. At the July 20, 2017 EITF meeting, the Task Force discussed the primary accounting question related to this Issue, which is how a customer should account for implementation, setup, and other upfront costs (referred as implementation costs) incurred in a cloud computing arrangement that is considered a service contract (Issue 3 in Issue Summary No. 1). At that meeting, the Task Force asked the staff to perform additional research with the objective of clarifying the existing alternatives presented by the staff or propose additional alternatives, as appropriate, to address the diversity in practice observed. * The alternative views presented in this Issue Summary Supplement are for purposes of discussion by the EITF. No individual views are to be presumed to be acceptable or unacceptable applications of Generally Accepted Accounting Principles until the Task Force makes such a determination, exposes it for public comment, and it is ratified by the Board. Page 1 of 33

2 2. The purpose of this memo is to update the Task Force on the additional research that the staff has performed and to present revised (or clarified) alternatives for this primary accounting question. If the Task Force reaches a tentative conclusion on that primary accounting question at its October 12, 2017 meeting, then the staff will present the remaining accounting questions related to this Issue for Task Force discussion. Background 3. In April 2015, the FASB issued Accounting Standards Update No , Intangibles Goodwill and Other Internal-Use Software (Subtopic ): Customer s Accounting for Fees Paid in a Cloud Computing Arrangement, to help entities evaluate the accounting for fees paid by a customer in a cloud computing arrangement (CCA) by providing guidance for determining when the arrangement includes a software license. Examples of CCAs include software as a service (SaaS), platform as a service (PaaS), infrastructure as a service (IaaS), and other similar hosting arrangements. A SaaS arrangement uses internet-based application software hosted by a service provider or third party (other than the service provider) and is the most common CCA. 4. If a CCA includes a license to internal-use software, then the software license is accounted for by the customer in accordance with Subtopic , Intangibles Goodwill and Other Internal-Use Software. This generally means that an intangible asset is recognized for the software license, and, to the extent that the payments attributable to the software license are made over time, a liability also is recognized. If a CCA does not include a software license, the entity should account for the arrangement as a service contract. This generally means that the hosting fees are expensed as incurred. 5. After Update was issued, several stakeholders requested that the Board provide additional guidance on the accounting for costs for implementation activities incurred in a CCA that is considered a service contract. Because of the lack of clear guidance in GAAP, those stakeholders observed that entities have looked to various areas of the Codification for additional guidance, which has resulted in diversity in practice. 6. On May 10, 2017, the Board decided to add a narrow scope project to the EITF s agenda to address a customer s accounting for costs for implementation activities incurred in a CCA that is considered a service contract. 7. The following issues were included in Issue Summary No. 1, which was presented to the Task Force at its July 20, 2017 EITF meeting: Issue 1: Definition of implementation costs Issue 2: Scope of the project Page 2 of 33

3 Issue 3: Accounting for implementation costs incurred in a cloud computing arrangement that is considered a service contract Issue 4: Amortization period, if applicable Issue 5: Analogizing to other service contracts. 8. Based on feedback received prior to the July EITF meeting, the staff determined that reaching a decision on Issue 3 was integral to any decision on the other issues included in Issue Summary No. 1. Issues 3 and 4 ultimately were discussed at that meeting. The remaining issues (Issues 1, 2, and 5) were not discussed. The staff expects that all issues presented in this Issue Summary Supplement will be discussed at the October 12, 2017 EITF meeting. 9. The issues in Issue Summary No. 1 have been renumbered in the order in which they will be presented to the Task Force at the October EITF meeting. For example, Issue 3 in Issue Summary No. 1 is now renumbered Issue 1 because it is necessary to resolve this issue before considering the other issues. Issues Issue 1 Accounting for Implementation Costs Incurred in a CCA That Is Considered a Service Contract 10. At its July 20, 2017 meeting, the Task Force considered the following four alternatives to account for costs for implementation activities incurred in a CCA that is considered a service contract: Alternative A Implementation Costs Associated with a CCA That Is Considered a Service Contract Would Be Recognized as an Expense When Incurred. Alternative B Implementation Costs Associated with a CCA That Is Considered a Service Contract Would Be Recognized as an Asset or an Expense When Incurred on the Basis of Existing GAAP (Topic 340, Subtopic , Topic 360 Subtopic ). Alternative C Implementation Costs Associated with a CCA That Is Considered a Service Contract Would Be Accounted for the Same as Implementation Costs Associated with a Software License. Alternative C 1 Implementation Costs Associated with a CCA That Is Considered a Service Contract Would Be Accounted for Based on Topic 360 (Costs to Get the Asset Ready for its Intended Use). Page 3 of 33

4 11. Task Force members did not express support for Alternative A or Alternative C 1, and, accordingly, the discussion focused on Alternative B and Alternative C and the differences between those two alternatives. 12. In evaluating Alternatives B and C, the Task Force discussed the extent to which multiple elements of implementation costs incurred in a CCA would need to be separated for accounting purposes. Ultimately, it generally was acknowledged that both Alternatives B and C require separation of multiple elements, and that, therefore, such a feature does not distinguish Alternative B from Alternative C. One Task Force member also observed that allocation guidance between multiple element arrangements exists in GAAP (for example, in Subtopic ), although it may not address all aspects (for example, when elements are distinct). During the discussion, a parallel to Topic 606, Revenue from Contracts with Customers, also was discussed. Specifically, certain members of the Task Force discussed the possible application of the notion of distinct goods or services to CCAs that are considered service contracts for purposes of separating elements of a contract under both Alternatives B and C. 13. Some Task Force members supported Alternative B because it relies on existing GAAP and is consistent with the prior decisions reached in Update and with the definition of an asset under FASB Concepts Statement No. 6, Elements of Financial Statements. However, other Task Force members expressed reservations with Alternative B, which they perceived as potentially having a different accounting outcome for identical costs depending on who performs the service. For example, some believed that certain implementation costs incurred by the cloud service provider (vendor) would be expensed over the life of the contract if considered not to be distinct from the hosting service, while those same costs would be expensed as incurred if the work is performed internally or by a third-party consultant. 14. Some Task Force members supported Alternative C because they considered CCAs that are considered service contracts to be economically similar to CCAs that include a software license. Some Task Force members asserted that a customer in a CCA that is considered a service contract has an asset; it is the right-to-use the asset even though it is serviced and maintained by an external party. However, some Task Force members expressed concerns with Alternative C, noting that it would require revisiting and undoing the prior decisions reached in Update if the Task Force wanted the guidance for implementation costs to be conceptually consistent with the accounting for the underlying hosting arrangement. An FASB staff member also observed that a CCA that is considered a service contract might not be economically similar to a right-to-use asset because the vendor still must perform throughout the term of the CCA in order for the customer to benefit from the arrangement and because the customer does not control the right to the asset (which is a key distinguishing factor between contracts that are and are not recognized on the balance sheet). Several Task Page 4 of 33

5 Force members also expressed concerns with Alternative C because the guidance in Subtopic is perceived as outdated and because there already are practice issues associated with applying the guidance in Subtopic to software licenses. They noted that applying the same guidance to implementation costs of a CCA that is considered a service contract might not reduce diversity in practice. 15. The Task Force ultimately directed the staff to perform additional research (focusing on Alternatives B and C) to assist the Task Force in reaching a tentative decision on the Issue. The following potential research areas were outlined by the FASB staff: a) Explore whether Alternative B could be improved (or clarified) to confirm whether or not there would be different accounting outcomes depending on who performs the implementation work. b) Analyze the issues that exist in practice for applying the guidance in Subtopic to software licenses, and whether those issues would exist when applied to CCAs that are considered service contracts. c) Consider how to separate elements of a contract. d) Build new examples for CCAs that are considered service contracts, with implementation activities that include additional complexities such as multiple-service providers (vendors, third-party consultants and internal). e) Explore whether a conceptual basis similar to Topic 842, Leases, could be applied, whereby a right-of-use asset is recognized even though control does not pass to the customer (similar to an operating lease). f) Evaluate whether any other model outside of Subtopic could be applied to CCAs that are considered service contracts. Stakeholder Feedback after EITF Meeting 16. Following the July EITF meeting, the staff performed outreach with five accounting firms in addition to four preparers and two vendors who participated in the EITF Working Group. The focus of this outreach was to ascertain more details around the concerns raised with Alternatives B and C, as well as obtain real examples of SaaS arrangements with multiple elements. Alternative B 17. With respect to Alternative B, one stakeholder suggested making a modification to Alternative B that would simplify its application. That is, instead of requiring entities to look to Topic 606 for determining whether costs for implementation activities not already addressed by other GAAP guidance should be considered distinct, that stakeholder suggested including simplified Page 5 of 33

6 guidance as part of Alternative B that would reduce the costs of applying it while yielding similar accounting outcomes in most cases. 18. Some stakeholders also indicated that the guidance about determining whether an activity is distinct from the hosting service based on the customer s perspective does not have to align with the evaluation that a vendor performs. That is, those stakeholders observed that it is not necessary to include guidance requiring customers to look to Topic 606; there could be different accounting models for customers versus vendors because the accounting does not have to be symmetrical. Alternative C 19. With respect to Alternative C, the staff performed additional outreach about the concerns that the guidance in Subtopic is outdated and would not be applicable to CCAs that are considered service contracts. 20. Most stakeholders agreed that Subtopic was written under a waterfall approach. This approach is a linear process to software development that flows in a sequential order from the preliminary phase to the application development phase, and then to the post-implementation phase. However, in the current environment, most software development happens under an agile approach, which involves a number of concurrent stages and differs from the linear approach described in Section In an agile environment, there are no distinct phases for the entire development process. For example, during the application development stage for one component of the software development, another component of the software development might still be in the preliminary project phase. Therefore, some may argue that it could be difficult to apply the guidance in Subtopic under an agile environment. 21. However, some stakeholders did not think that this would be an issue for CCAs in general because the software typically has already been developed (there is minimal coding). The implementation activities will be those activities that are incurred to get the CCA ready for its use. Therefore, some stakeholders did not think that it would be difficult to apply the guidance in Subtopic to a CCA that is considered a service contract. Other stakeholders also noted that a CCA generally is past the preliminary project phase when the customer enters into the arrangement. Advisory Committees Feedback 22. The staff met with the Not-for-Profit Advisory Committee (NAC) and the Private Company Council (PCC) to obtain feedback on this Issue. Some NAC members observed that they do not see a difference between an on-premise software license and a CCA that is considered a service contract. Those NAC members noted that the same business decisions are made whether they have the right to take possession of the software or not. One NAC member also Page 6 of 33

7 noted that having the right to take possession of the software generally is not a key determinant in the negotiations and that cloud service providers generally do not permit the customer to take possession of the software. 23. Following that feedback, the staff performed additional outreach with preparers (customers in CCAs) and cloud service providers. Those stakeholders noted that customers in CCAs generally no longer have the ability to take possession of the software without losing the benefits associated with a CCA (for example, the consistent experience for all customers and the optimized environment of not having to maintain multiple versions) and for proprietary reasons. Although there are significant implementation costs, there are significant benefits related to infrastructure, making CCAs a favorable alternative to an on-premise solution. Therefore, customers who negotiate with cloud service providers generally already have accepted the CCA model without needing to take possession of the software. One customer the staff spoke with noted that it would be nice to have the ability to take possession of the software but that it is not an expectation nor a deal breaker. One cloud service provider and a customer also observed that the terms of a CCA typically do not include the ability to take possession of the software license. 24. Feedback received from the PCC generally was consistent with feedback received from the NAC. PCC members observed that they view CCAs as economically similar to internal-use software licenses. They noted that the functionality is the same but that the accounting is based on one aspect (the right to take possession of the software) that customers do not regard as important when negotiating CCAs. It also was discussed that contracts for CCAs convey significant rights to the customer and that the concept of control should not be binary (that is, solely based on the right to take possession), especially in a digital environment. One PCC member observed that the phases described in paragraph (which apply to internaluse software) are consistent with the phases that a customer goes through for a CCA. 25. PCC members generally preferred Alternative C, but acknowledged that what is more important is to align the accounting for CCAs with the accounting for internal-use software licenses, rather than what the actual model or alternative selected is. While a PCC member (user of financial statements) noted that intangible assets generally are not considered in their analysis, it also was acknowledged that the purpose of financial statements is broader than just the lenders use of those financial statements. It also was observed that the accounting for customers and vendors does not have to be symmetrical. Finally, one PCC member noted that she did not think there would be practice issues with applying the guidance in Subtopic to CCAs that are considered service contracts. Page 7 of 33

8 Summary of Revised Alternatives 26. Based on the feedback received at the July EITF meeting and the subsequent outreach and research performed, the staff considered several modifications that could be made to Alternatives B and C. 27. One important change to Alternative C is that the revised alternative would expand the amendments made in Update such that all CCAs would include a software element and be within the scope of Subtopic on internal-use software (not just those CCAs that include a software license based on paragraph A) under the premise that all CCAs provide an economic resource to the customer, irrespective of ownership or location of the software. This important change was primarily driven by the additional feedback received both at the EITF meeting and subsequently through discussions with stakeholders. But the change also was influenced by the additional research that the staff performed in evaluating whether there would be other ways to determine whether costs for implementation activities result in the creation of an asset for the customer when the premise for such analysis is that the CCA is a service contract (other than requiring entities to recognize a prepaid asset for costs of implementation activities that are not distinct based on the guidance in Topic 606 under Alternative B). As further explained in the details of Alternative B, the staff could not identify a conceptual basis to capitalize service costs in preparation for another service. 28. The change to Alternative C also was made to make the accounting for the implementation costs conceptually consistent with the underlying hosting arrangement. In Subtopic , costs associated with implementation activities are not capitalized as a separate or stand-alone asset. Instead, the software is the identified asset and costs of implementation activities are added to the measurement of the software asset if they are incurred to get the asset ready for its intended use. Alternative C was revised to identify a software element (and the right-to-use that software) in all CCAs, which is the asset to which implementation costs can be added. 29. The following are the revised (or clarified) alternatives for the Task Force to consider: Alternative B Residual Approach Utilizing Guidance in Topic 606 to Determine What Is Distinct Implementation costs associated with a CCA that is considered a service contract would be recognized as an asset or an expense when incurred on the basis of existing GAAP (specifically, Topic 340, Subtopic , Topic 360, or Subtopic ). Implementation costs that are not addressed by existing guidance would be expensed as incurred if the related activities are considered distinct from the hosting service (based on Topic 606) or capitalized as a prepaid asset for the services if the related activities are not distinct (based on Topic 606). Page 8 of 33

9 Alternative C All Hosting Arrangements (as Defined in the Master Glossary) Are Within the Scope of Subtopic All CCAs would include a software element, which would be accounted for the same as internal-use software licenses. 30. Appendix A provides an illustrative example of the treatment of implementation costs incurred in a CCA that is considered a service contract under Alternatives B and C. While the staff was asked to build multiple examples for CCAs that are considered service contracts with different complexities, the staff developed this illustrative example to include the various complexities that were identified during the stakeholder outreach; specifically, various implementation activities and multiple-service providers (vendors, third-party consultants, and internal employees). Other Considerations Customization versus Configuration 31. Important to the understanding of the Alternatives for Issue 1, particularly Alternative B, is the distinction that exists between the terms customization and configuration. Customization refers to a modification to the software that requires custom coding, and/or some form of implementation. Configuration activities simply refer to the use of the native tools in the system and change its behavior or features (for example, changing settings, selecting filters, and so forth). Configuration activities do not modify or add software code; they simply configure functionality that already exists in the software code. Separation of Elements in a Multiple Element Arrangement 32. At the July EITF meeting, there were discussions about how a customer would separate elements of a CCA that is considered a service contract, which is relevant for both Alternatives B and C. However, the staff notes that this is not a new accounting question and it is not a question isolated to CCAs. In the application of other GAAP guidance entities may be required to separate elements of a contract, but there is not always guidance about when to separate or how to separate those elements. In the context of CCAs, paragraph BC4 of Update acknowledged that some CCAs may even include one or more licenses to software as well as a promise to provide services, in which case the customer should allocate the contract consideration between the license(s) and the service element(s). But Update did not provide explicit guidance about when to separate or how to separate the various elements of a CCA that includes a software license. 33. Ultimately, the staff believes that separation of elements of a contract is beyond the scope of this Issue and that entities, for example those that currently apply the guidance in Subtopic , already are separating elements. In addition, depending on the Task Force decision on this Issue, it is possible that the terms of contracts will provide more detailed breakdowns of Page 9 of 33

10 activities, which would assist entities in separating elements. Accordingly, the staff does not plan to propose guidance about separation of elements for this Issue. Questions for the Task Force 1. Which accounting alternative does the Task Force want to select for Issue 1? 2. If the Task Force selects Alternative B, does the Task Force want to add specific (and simplified) guidance about whether activities are distinct or does the Task Force want to require entities to look to the guidance in Topic 606 to determine what activities are distinct? 3. If the Task Force selects Alternative C, does the Task Force agree with the staff recommendation to not add guidance about how to apply Subtopic to CCAs? 4. If the Task Force selects Alternative C, does the Task Force want to add guidance to address practical questions related to the capitalization of the software element of a CCA? 5. If the Task Force agrees to add guidance to address the practical questions related to the capitalization of the software element of a CCA, does the Task Force want the staff to perform additional research on those questions or does the Task Force want to require entities to analogize to the existing guidance in Topic 842? 6. Does the Task Force agree with the staff recommendation not to provide guidance about how to separate elements of a CCA? Staff Analysis Alternative B Residual Approach Utilizing Guidance in Topic 606 to Determine What Is Distinct 34. Alternative B fundamentally is a residual approach in that an entity would apply existing GAAP guidance (for example, Topic 340, Other Assets and Deferred Costs, Subtopic , Topic 360, Property, Plant and Equipment, or Subtopic , Other Expenses Business and Technology Reengineering) to the arrangement to determine whether costs related to specific implementation activities should be recognized as an asset or, instead, expensed as incurred. One aspect of this residual approach, if the costs are not already addressed by other GAAP guidance, would be to determine whether the activities related to those costs are distinct from the hosting service using the guidance in Topic 606. Costs for these residual implementation activities should be expensed as incurred if considered distinct from the hosting service or recorded as a prepaid asset if considered not distinct. 35. Some of the guidance upon which Alternative B is based (that is, Topic 340, Subtopic , Topic 360, and Subtopic ) has been applied in practice for an extended period and, Page 10 of 33

11 therefore, many stakeholders already are familiar with such guidance. But some of the guidance also would be new, such as the application of the distinct guidance in Topic The following table sets forth the scope of the accounting guidance for typical costs or activities in a CCA under Alternative B: Guidance Example Costs or Activities within Applicable Guidance Subtopic Software licenses acquired for set-up and implementation of CCA Coding and configuration of customer s on-premise systems Topic 360 Hardware acquired for the set-up and implementation of CCA (for example, laptops, tablets, servers, and other equipment) Topic 340 Assets for prepayments of services not yet performed (for example, a prepaid asset for a service to be performed by a consulting firm over a six-month period that the customer pays at inception of the contract) Subtopic Business process reengineering activities Topic 606 Residual activities, such as customization and configuration of the hosted software, training employees to effectively use the cloud solution, data migration, or conversion activities; unless those activities are addressed in other GAAP guidance. If the activities are considered distinct based on the application of Topic 606, costs for those activities would be expensed as incurred. 37. Alternative B would be consistent with the amendments described in Update because, as described in paragraph BC6 of that Update, the amendments were intended to align the customer s evaluation of whether it is obtaining a software license or a service in a CCA with the evaluation that the provider undertakes. 38. Proponents of Alternative B also note that the amendments in Update : a) Were conceptually sound The amendments effectively distinguish between a contract for a software license (that is, one in which the customer obtains an asset) and one for services. When the criteria in paragraph A are met, the cloud service provider has transferred an asset to the customer and the customer controls an asset from which it can derive economic benefits independent of the cloud service provider s performance. CCAs that do not meet those criteria are similar to other service contracts Page 11 of 33

12 that require continued and active performance by the vendor and do not transfer an asset to the customer at service commencement. b) Promoted consistency between vendors and customers in determining whether an asset is acquired The amendments were derived from guidance that already existed for vendors. 39. Opponents of Alternative B argue that costs for configuration activities to implement a CCA that is considered a service contract generally would be expensed as incurred see below for additional details. Based on feedback received from stakeholders, costs for configuration activities can be one of the largest implementation costs. These opponents explain that these configuration costs are costs to get the CCA ready for its intended use, and therefore should be capitalized rather than expensed as incurred. 40. Some opponents of Alternative B also note that if the CCA cannot function as intended without the other services, then the activity is not distinct, regardless of who performs the work. Therefore, they do not agree that cost for configuration activities should be expensed as incurred because they view those activities as integral to the use of the hosted software. Consistency in Accounting Outcomes Irrespective of Who Performs the Work 41. At the July EITF meeting, some Task Force members expressed reservations with Alternative B, which they perceived as potentially resulting in a different accounting outcome for identical costs depending on who performs the service. However, the staff believes that the application of Alternative B would result in consistent accounting outcomes. Accordingly, the staff would like to clarify the application of the distinct guidance in Topic 606 to certain costs for implementation activities that are not already addressed by existing GAAP guidance. Those costs would include, for example, customization and configuration of the vendor s software. It is presumed, in this analysis, that such activities transfer a good or service to the customer. That is, those activities are not simply administrative tasks to set up the contract; they provide incremental benefits to the customer beyond merely accessing the hosted software. In addition, customization activities included in this discussion are those applied to the vendor s software only. If customization services were performed on the customer s on-premise software, those activities would be within the scope of Subtopic Paragraphs through (along with the implementation guidance and illustrations) provide the guidance for determining whether a promised good or service is distinct. The two criteria that must be met for a good or service to be distinct is that the good or service is capable of being distinct (the primary guidance being in paragraphs (a) and ), and that the good or service is separately identifiable in the context of the contract (the primary guidance being in paragraphs (b) and ). Page 12 of 33

13 43. In general, customization activities will not be considered a distinct good or service under Topic 606. This could be because the customization services are not capable of being distinct (for example, if the cloud service provider does not regularly sell customization services separately and the solution does not function without the customization services). This also could be because the customization services are not separately identifiable in the context of the contract. Specifically, the customization services generally significantly modify and/or customize the software, and the software together with the customization services are inputs to the combined output for which the customer has contracted. Accordingly, the software and related customization activities typically will comprise a single performance obligation from a vendor perspective. Note that for this analysis the staff excluded situations in which customization of the vendor s software is performed by a consultant unrelated to the vendor because, based on feedback obtained during outreach, cloud service providers generally do not permit third parties to customize (that is, change the coding of) the vendor s software for proprietary reasons. 44. Other implementation activities, such as configuration activities, training, or data conversion, typically would be considered separate performance obligations from a vendor perspective, irrespective of who performs the activity. These activities generally will be capable of being distinct, and will be separately identifiable in the context of the contract because those activities generally will not modify or customize the cloud service provider s software, and, consequently, also will not be inputs to a combined output. While there could be situations in which activities, such as configuration activities, may not be considered separately identifiable in the context of the contract (for example, because of specialized configuration activities that only the cloud service provider can perform, the vendor cannot fulfill its promise to transfer access to the hosted software separately from its promise to perform the configuration services), the staff generally believes that this would be the exception rather than the rule in the context of CCAs. Accordingly, services provided for activities other than customization activities will be distinct services to the extent that an entity other than the cloud service provider could provide those professional services, which generally will be the case for CCAs. 45. However, considering the perceptions around Alternative B and subsequent feedback obtained, the Task Force could simplify the application of Alternative B by including explicit guidance to determine whether implementation activities are considered distinct, rather than referring entities to Topic 606. Accordingly, the staff considered including the following explicit guidance within Alternative B that would be used to determine whether an activity is distinct from the cloud service provider s hosted software. This proposed guidance would apply to those residual activities not addressed by other GAAP guidance, and would result in a conclusion that generally is consistent with that which would be reached if an entity applied the guidance in Topic 606. This guidance would be based on the following questions: Page 13 of 33

14 a) Does the implementation activity transfer a good or service to the customer? If no, the activity is a setup or administrative activity and the costs for those activities may be considered a prepaid asset. If yes, go to the next question. b) Is the implementation activity that is being performed or provided significantly customizing the hosted software? If yes, the activity is not distinct from the hosted software and the costs for those activities may be considered a prepaid asset. If no, go to the next question. c) Could the implementation activity be provided by someone other than the vendor (that is, a third-party consultant or internally), ignoring contract restrictions, or is it sold separately by the vendor (that is, the customer could choose to purchase it)? If yes, then regardless of who performs the work, the activity would be considered distinct and therefore the costs for those activities would be expensed as incurred. If no, then the activity is not distinct from the hosted software and the costs for those activities may be considered a prepaid asset. 46. Appendix A of this Issue Summary Supplement provides a fact pattern that includes various implementation activities performed by a combination of the vendor, a third-party consultant other than the vendor, and internal employees. As illustrated in Appendix A, there would not be a different outcome depending on what party is performing the work. However, there would be different accounting outcomes for configuration activities and customization activities. Other Approaches Considered 47. Considering feedback received that it is not necessary to include guidance requiring customers to look to Topic 606 to determine whether costs for implementation activities not already addressed by other GAAP guidance are distinct, the staff explored whether other guidance could be developed; that is, a model in which the accounting for customers and vendors would not be symmetrical. 48. The staff appreciates the concerns raised under Alternative B stating that costs for configuration of the vendor s software, which generally are significant to CCAs, would be expensed as incurred. The staff therefore focused on those costs to explore whether there would be a conceptual basis for recognizing such costs as an asset in all cases, irrespective of who performs the work. If a conceptual basis existed, then the staff would test that basis against other implementation activities not addressed by existing GAAP guidance. This would allow for more implementation costs to be capitalized, while remaining conceptually aligned with Update That is, the assumption in this analysis is that the CCA is a service contract under Update Page 14 of 33

15 49. One common example found in CCAs is that configuration activities will be performed by a third-party other than the cloud service provider. A cloud service provider generally has an ecosystem around it for the performance of various activities that do not represent its core strategy and/or business model. For example, consider a customer that enters into a CCA (considered a service contract) with a cloud service provider for a non-cancelable term of five years, and the customer hires a third-party consultant to perform configuration services, which are expected to be performed over a six-month period. 50. Paragraph 25 of CON 6 defines an asset as follow: Assets are probable future economic benefits obtained or controlled by a particular entity as a result of past transactions or events. The term probable was included in the definition to acknowledge that business and other economic activities occur in an environment characterized by uncertainty in which few outcomes are certain. The term future economic benefits sometimes has been misinterpreted as meaning that the asset is the ultimate future inflow. Inflows, however, are produced as a consequence of having an asset. Although the wording may suggest equating the asset with future economic benefits, the asset is something that exists in the present rather than in the future. The staff will illustrate that aspect of the definition of an asset in the context of the example CCA previously described. 51. In the evaluation of the term future economic benefits, the asset represented by the 6-month contract for configuration services is the present right for the customer to have the consultant(s) perform the configuration services; the asset is not the eventual future flow that will follow once the consultant s (consultants ) work is completed. That is, although the customer will utilize the configuration settings over the five-year term of the CCA, this flow is not relevant to the recognition of an asset for the contract for configuration services. In other words, the rights from the contract with the consultant are different from the flow that follows their work (the flow is not a present right). This interpretation of the conceptual framework was clarified and confirmed at the August 30, 2017 Board meeting on Conceptual Framework project Elements, and is consistent with the working definition being developed for the definition of an asset. 52. CON 6 also explains that services provided by other entities cannot be stored and are received and used simultaneously. They can be assets of the entity only momentarily (as the entity receives and uses them), although their use may create or add value to other assets of the entity. However, for a CCA that is considered a service contract, the customer does not have an asset to which the configuration activities create or add value. Accordingly, there is no conceptual basis to capitalize costs for configuration activities in all cases, and, therefore, the staff did not expand that research to other implementation costs. On the other hand, the outcome of this analysis would be different if the CCA were considered an asset of the Page 15 of 33

16 customer, which will be further explored in Alternative C since Alternative B remains aligned with the decisions made in Update Alternative C All Hosting Arrangements (as Defined in the Master Glossary) Are Within the Scope of Subtopic Original Alternative C 53. Under the original Alternative C for Issue 3 (as presented in Issue Summary No. 1), implementation costs associated with a CCA that is considered a service contract would be accounted for in the same manner as implementation costs of an internal-use software license. However, the hosting fees would still be expensed as incurred considering the executory nature of the CCA. 54. Effectively, under the original Alternative C, an entity would expense those costs that are incurred in the preliminary project and post implementation-operation stages. Costs incurred for integration with on-premise software, coding, and configuration or customization activities would be capitalized in accordance with Subtopic Costs incurred for data conversion and training would be expensed as incurred, and any costs for business process reengineering would be accounted for in accordance with Subtopic Proponents of Alternative C support this approach because they view CCAs that are service contracts as economically similar to internal-use software licenses. Some proponents of this alternative also note that a customer in a CCA that is considered a service contract has an asset; it is the right-to-use an asset although it is serviced and maintained by an external party. 56. Opponents of the original Alternative C have concerns with the conceptual merits of that alternative. The conceptual construct of Alternative C, if Update remains in place, is about capitalization of services in preparation for other services. However, there are few (if any) similar circumstances in existing GAAP. Initial direct costs of an operating lease are capitalized under Topic 840, Leases, and Topic 840 does not require lessees to recognize operating leases on the balance sheet. However, Topic 842 will supersede Topic 840 and will require that lessees recognize all leases on the balance sheet, other than short-term leases. While some proponents of Alternative C cite leasehold improvements as another example, Topic 842 again will require lessees to recognize most leases on the balance sheet. 57. While the accounting for implementation costs would be consistent between CCAs that include a software license and CCAs that are considered service contracts, opponents of the original Alternative C also note that the accounting for the hosting fees would not be consistent. Specifically, in a CCA that includes a software license, the hosting fees attributable to the software license must be capitalized as an intangible asset with a corresponding liability to the extent the fees are paid over time (with an element of time value of money). In contrast, if a Page 16 of 33

17 CCA does not include a software license, the hosting fees are expensed as incurred. This inconsistency in accounting in turn would result in differences in presentation on the income statement, in classification on the statement of cash flows, and in presentation and outcomes on entities performance metrics, such as EBITDA (although a non-gaap metric). 58. The GAAP differences related to the hosting fees between CCAs that include a software license and CCAs that are considered service contracts are illustrated in the table below. These differences would not be in line with proponents of Alternative C s view that CCAs that are service contracts are economically similar to software licenses. Financial Statement CCA Includes a Software License CCA Is Considered a Service Contract Balance Sheet Intangible asset Liability (unless fully paid at initial asset recognition) N/A, or prepaid asset (accrued expense) depending on timing of payments in relation to the service Income Statement Amortization expense for the intangible asset Interest accretion on the liability Operating expense Statement of Cash Flows Investing outflows (for prepayments) Financing outflows (principal) and generally operating outflows (interest) Operating outflows 59. Some opponents of Alternative C also note that the decisions made in Update were based on guidance that already existed from a vendor perspective (that is, Subtopic on revenue recognition for software). Alternative C might question the validity of the decisions made in Subtopic and potentially of those made in Topic 606 (which retained that same guidance for determining whether a vendor is selling a software license or a service). Revised Alternative C 60. Based on the feedback received on Alternative C and the preceding discussion, the staff explored ways to improve Alternative C. CCAs are growing rapidly, with more and more entities entering into CCAs to obtain finance, administrative, and operational solutions. Based on feedback received from NAC members, PCC members, and other stakeholders, having the right to take possession of the software generally is not a key negotiation point for the customer, and cloud service providers generally do not permit customers to take possession of the software for proprietary reasons. Accordingly, many if not most CCAs are being accounted Page 17 of 33

18 for as service contracts based on the amendments in Update (which was the expectation at the time the Update was issued). However, proponents for capitalization note that the functionality obtained in a CCA is often indistinguishable from that obtained in an onpremise software solution, so a software element should be accounted for in all CCAs. They note that the customer s ability to take possession of the software should not be the key determinant because the functionality of the underlying software, and the customer s use, is the same regardless of whether the software is delivered through the cloud or an on-premise software license. In other words, the customer has an economic resource irrespective of ownership or location of the software. In addition, the staff observes that accounting standards, particularly in recent years, have moved away from a binary conception of control (for example, from FASB Statement No. 66, Accounting for Sales of Real Estate, to Topic 606 where legal title now only is an indicator of control). 61. The staff believes that, if a version of Alternative C continues to be proposed, such an alternative should in effect converge the accounting for CCAs that are considered service contracts with the accounting for CCAs that include a software license. Said differently, the staff believes that there should be a similar accounting outcome for the implementation costs of a CCA and for the hosting fees. This would be consistent with feedback that said that CCAs that are considered service contracts are economically similar to software licenses. 62. The staff acknowledges that this revised Alternative C would expand the scope of Update to all CCAs, but it would do so based on additional information obtained since the issuance of that Update. The definition in the Master Glossary of hosting arrangement added with Update would be retained and would be used in Alternative C to determine those transactions that are within the scope of Subtopic The Master Glossary defines a hosting arrangement as: Hosting Arrangement In connection with the licensing of software products, an arrangement in which an end user of the software does not take possession of the software; rather, the software application resides on the vendor s or a third party s hardware, and the customer accesses and uses the software on an as-needed basis over the Internet or via a dedicated line. 63. This revised Alternative C would be detached from the vendor s perspective, but this would be done consistent with feedback that said that an alignment between customers and vendors is not required. 64. The staff acknowledges that additional effort may be required to separate the software element from the hosting service and allocate the hosting fee to each element under the revised Alternative C. However, the Task Force could address that issue by allowing an entity to not separate the hosting service from the software element, similar to the practical expedient Page 18 of 33

19 provided in paragraph that allows a lessee not to separate nonlease components from the lease components to which they relate, and instead account for each separate lease component and the nonlease components associated with that lease component as a single lease component. 65. Opponents of the revised Alternative C are concerned that it would require an entity to recognize service contracts on the balance sheet. They note that this would be inconsistent with the Conceptual Framework, in part because the customer does not control the service. The customer expects to receive the service and it might have some legal recourse if it does not receive the service, but it does not control the service. The service does not exist before it is performed. Opponents also note that the revised Alternative C would be inconsistent with the accounting for most other service contracts. While it is fair to say that in a CCA, the customer has contracted for hosting for a period of time at a specified price, the same could be said of many other arrangements that are not recognized on the balance sheet (for example, cleaning and maintenance or consulting). 66. Opponents of the revised Alternative C also are concerned with the additional effort that it would require. They note that customers would be required to separate the software element from the hosting service and allocate the hosting fee to each element. This separation would be subject to significant judgment because there may not be objective evidence of the fair value of the software element when the CCA vendor does not separately sell a license to the underlying software element or when the functionality of the software element and the hosting service are interdependent. Opponents also note that the revised Alternative C requires additional effort related to the requirement to capitalize the software element of a CCA, as further described starting at paragraph Refer to Appendix A of this Issue Summary to see the detailed example of the accounting outcome based on the revised Alternative C. Concerns with Applying Subtopic to CCAs 68. At the July EITF meeting, several Task Force members expressed concerns with Alternative C because the guidance in Subtopic is perceived as outdated, and there already are practice issues associated with applying the guidance in Subtopic to software licenses. Therefore, they noted that applying the same guidance to implementation costs of a CCA that is considered a service might not reduce diversity in practice. 69. However, based on the feedback received through outreach performed subsequent to the EITF meeting, it does not appear that there would be significant challenges in applying the guidance in Subtopic to CCAs that are considered service contracts. Some stakeholders even noted that there are many situations in which there is a combination of on-premise software solutions and a CCA that is considered a service contract, which interface with one another. Page 19 of 33