The following is a guest post from Peter Madara, founder and principal at GAAPTUS Consulting. Opinions are the author’s own.
Accounting for software costs has been in the news lately with the Financial Accounting Standard Board (FASB) deciding to move forward with certain targeted improvements at its June 18th, 2024 meeting. There is, however, a more imminent issue that CFOs and chief accounting officers (CAOs) need to pay attention to, namely accounting for the purchase of subscription-based software licenses. CFOs and CAOs are often surprised to learn that their companies have been getting the accounting wrong all along. Worse still, they are even more surprised that even their external auditors failed to detect the wrong accounting.
For the longest time, software was sold through perpetual licenses, meaning you paid once and could use the software forever. Accounting for these licenses is simple: The perpetual license fee is recorded as capital expenditure and the associated software maintenance fee is recorded as a prepaid cost and amortized into operating expenses (OpEx).
Over the past decade, the industry shifted to subscription-based licenses, where you pay for the software use over a specified term. Today, almost every company uses subscription-based software licenses. The subscription contracts typically bundle software that was previously sold via perpetual licenses, software maintenance and other cloud-based services into a single subscription fee.
The accounting issue
Many companies often wrongly assume that all software-related subscription fees should be recorded as prepaid costs and amortized into OpEx. However, in some cases, GAAP requires subscription payments to be handled as settlement of vendor-provided financing for acquiring a software asset. In such cases:
- A financed “software asset” must be recorded based on the portion of the single subscription fee attributable to software licenses.
- A liability must be recorded for the obligation to make future payments related to the financed software asset
A good example is a Microsoft 365 subscription which includes various software elements, software support and cloud-based services. Depending on the specific Microsoft 365 product, anywhere from 30% to 60% of the subscription fees are required to be recorded as vendor-provided financing for software assets previously sold via perpetual licenses.
Impact on financial statements
Several impacts need to be considered. Here are the primary ones.
- Balance sheet: Wrong accounting results in understatement of software assets (typically included in property, plant and equipment or intangible assets) and understatement of liabilities.
- Income statement: Understatement of depreciation and amortization expenses and interest expense, and overstatement of OpEx.
- Non-GAAP EBITDA: For companies that look to non-GAAP EBITDA as a comparable measure relative to peers, EBITDA is understated due to overstatement of OpEx.
- Cash flow statement: “Vendor financing payments” wrongly included in cash flow from operating activities instead of cash flow from financing activities.
If a company records 100% of its software-related subscriptions as prepaid costs amortized into OpEx, then it is almost a certainty that the accounting for vendor-financed software assets is not being handled correctly. In addition, a potential accounting error is also detectable from public company financial statements. Here are a few indicators that a company may not be handling the accounting correctly:
- MD&A commentary where increases or decreases in OpEx (that is, not considering depreciation and amortization expenses) are attributed in part to software license fees.
- Purchase commitments disclosures which indicate that material cash commitments include those for software licensing.
- Cash flow statement where the financing activities section has no line item that could possibly include vendor-financed software payments.
Next Steps for CFOs and CAOs
The steps outlined here apply to any situation where the CFO and CAO become aware that their financial statements might contain an accounting error. They are expanded to provide additional insights specific to subscription-based software licenses.
1. Verify whether your company is handling the accounting correctly
First and foremost, verify whether your company is correctly handling the accounting for subscription-based software licenses. For example, if your company records 100% of all its software-related subscriptions as prepaid costs amortized into OpEx, then it’s almost a certainty that there is an accounting error.
2. Assess the magnitude of potential error
If your company’s software-related subscription spending is significant in aggregate, then the next step is sizing up the potential magnitude of the accounting error. In many cases, the error is at least big enough to warrant being reported to the audit committee.
CFOs and CAOs need to ensure their accounting team has the appropriate expertise to assess whether a subscription includes vendor-financed software assets and how to allocate fees between vendor-financed software assets and other elements.
3. Engage external auditors
Inform auditors early, as they might need to consult their national office if the error is material. Keep auditors updated on significant judgments made in quantifying the error.
4. Consider the impact on internal control
The CFO and CAO will need to identify the root cause for why the company was unable to detect the error for a long time to determine the necessary remediation. There is no single right answer here, but almost always the failure can be traced back to at least one or more of the following:
- Risk assessment process failure: Inadequate due diligence on software subscriptions as they became significant.
- Ineffective training program: Although many companies have training programs, sometimes the amount of training carried out is inadequate training, and ineffective training delivery methods may be employed, resulting in accounting staff being unable to identify and detect potential errors.
