A retailer signs a five-year cloud-hosting arrangement with a vendor under which the vendor's software is accessed remotely over the internet; the retailer never takes possession of the software and has no right to run it on its own hardware, so the arrangement is a hosting arrangement that is a service contract rather than a software license. After completing the preliminary project stage, the retailer's IT staff spend $400,000 configuring and testing the hosted system to integrate with its point-of-sale data before go-live. Under ASC 350-40 as amended by ASU 2018-15, how should the retailer account for this $400,000 of implementation costs?
- Capitalize the $400,000 as a prepaid asset on the balance sheet (not as internal-use software or property, plant and equipment), applying the same stage-based recognition criteria used for internal-use software, and amortize it on a straight-line basis over the term of the hosting arrangement, presenting the amortization in the same income statement line item as the hosting fees
- Expense the $400,000 immediately, because costs incurred in a hosting arrangement that is a service contract can never be capitalized since the retailer never obtains a software license or takes possession of any asset
- Capitalize the $400,000 as an internal-use software intangible asset under the same balance sheet caption used for internally developed software, amortized over the software vendor's expected product life cycle rather than the hosting contract's term
- Capitalize the $400,000 as leasehold improvements to the retailer's existing IT infrastructure, amortized over the remaining useful life of that infrastructure
Why A? And why not the others?
Correct answer: A. Capitalize the $400,000 as a prepaid asset on the balance sheet (not as internal-use software or property, plant and equipment), applying the same stage-based recognition criteria used for internal-use software, and amortize it on a straight-line basis over the term of the hosting arrangement, presenting the amortization in the same income statement line item as the hosting fees
ASU 2018-15, codified in ASC 350-40, requires a customer in a hosting arrangement that is a service contract to apply the same capitalization criteria used for internal-use software to the implementation costs of that arrangement: costs incurred in an application-development-stage-equivalent activity, such as configuring and testing the hosted system for the customer's own use, are capitalized. However, because no software license or other asset is obtained, the capitalized amount is presented on the balance sheet as a prepaid asset rather than as internal-use software or property, plant and equipment, and it is amortized straight-line over the term of the hosting arrangement, with the amortization expense presented in the same income statement line as the related hosting fees. The option expensing everything immediately describes the rule that applied before ASU 2018-15, when hosting arrangements were treated purely as service contracts with no capitalization at all; ASU 2018-15 specifically changed this by aligning the accounting with internal-use software while stopping short of calling the result software or a licensed asset. The option treating the cost as internal-use software under the internal-use software caption, amortized over the vendor's product life cycle, misapplies the balance sheet presentation and the amortization period, which is tied to the hosting contract term, not any external product cycle. The option treating the cost as leasehold improvements to IT infrastructure has no basis in ASC 350-40, since nothing here involves leased physical space or equipment.
Source: FASB ASC 350-40-25 and 350-40-35, as amended by ASU 2018-15 (customer's accounting for implementation costs of a hosting arrangement that is a service contract)