There have been several major changes in the way businesses address service contracts in recent years given the new standards and updates on the existing standards.
For one, the new lease accounting standards have made accounting for leases more complicated while the Accounting Standard Update or ASU 2018-15 has provided clarity and simplified cloud computing contracts accounting. Just what exactly are the changes in accounting for long-term service contracts? Here’s a rundown.
Is a Service Contract an Asset?
Before we get into a deep dive into service contract accounting journal entries, we must first discuss whether a service contract is an asset. Certain contracts like sales contracts, employment, affiliation, and advertising can be treated as intangible assets since they provide value to a business. For example, contracts like long-term leases with below-market rates offer a big overhead saving. Or subscription contracts for a cable company or other long-term service contracts that provide revenues for a firm are examples of intangible assets.
What Happens When Leases Are Embedded in Service Contracts?
IFRS 16 and ASC 842 mandates businesses to be more transparent when it comes to their lease obligations. Compliance with these two standards means evaluating service contracts to identify which have embedded leases. Unfortunately for companies, the determination of embedded leases is a tedious and time-consuming task. A survey by KPMG showed that identifying embedded leases was ranked as the fourth most difficult aspect of implementing the new standards.
There are no shortcuts available to firms when it comes to determining embedded leases. Plus, one has to have a good grasp of what constitutes a lease given that contracts do not usually contain words like “rent” or “lease.”
Below is an example of how to evaluate a contract.
Company Y has a warehouse contract with AB Warehouse. AB warehouse provides the warehouse facility, monitors, and equipment for Company Y. The contract states that Company Y will have full usage of the facility, equipment, and monitors. The contract details each item that can be used by Company Y.
Company Y has 100 percent control over the warehouse facility, equipment, and monitors and will gain substantial benefits from the warehouse. The equipment portion of this contract between Company Y and AB warehouse meets all the criteria of an embedded lease of the standards given the following:
- The assets are identified
- Company Y has full control of the identified assets
- Company Y gains almost all of the economic benefits from the identified assets
Generally, logistics, security, and warehousing contracts have embedded leases.
How to Account for Software Leases and Cloud Computing Contracts?
The FASB in 2018 released new guidelines on how firms must do the accounting for the upfront costs and implementation related to cloud computing contracts. The standard update, Customer’s Accounting for Fees Paid in a Cloud Computing Arrangement in ASU 2015-05 clarifies how businesses must treat software as service contracts.
The new guidance says that the phrase “hosting arrangement” is now applicable or covers any arrangement that allows customers to use or have access to the software but without real possession. This means businesses have to account for implementation costs on cloud computing arrangements just like one accounts for the related internally-hosted software arrangements.
The new guidance and new standards on accounting for service contracts can be too much for companies. The new standards may have clarified the processes but these simplification and clarification are offset by the tedious work in complying with new accounting guidance. After all, there’s too much legwork in determining whether contracts have embedded leases or not and businesses may need to implement new processes to identify which ones have embedded leases. Fortunately, there are reliable service providers like Visual Lease that can make the transition to new standards easier.