It was the best of times, it was a cell with a view
Recently there has been a lot of discussion and debate regarding the capitalizing and amortizing of cloud-related expenses (sample posts here and here). Through most of what I read, people are on to the key items and we may have more of a semantic difference than a difference of opinion. In a previous article I discussed how beneficial, if not how absolutely necessary, a close relationship between a private cloud provider and their Finance team is. This debate is a great illustration of why I believe that to be the case. So I encourage you work with your Finance team to determine the best (and legal) course of action for your circumstance. What follows is based upon my specific experience wrestling with this issue.
A Capital Idea
When a tangible asset is purchased outright it can typically be depreciated over a reasonable period not to exceed its useful life (this was usually 3-5 years for us). Once the asset is no longer of use to an organization it can be disposed of. When that happens, if the asset is sold for more than its value (minus the amount it has been depreciated) a gain must be claimed. If the entire value of the asset has not been depreciated and the asset is not sold, or if it is sold for less than its residual value, it may be possible to claim a loss on its disposal. (Typically, we fully depreciated our assets and there was no gain or loss on their disposal.) The rationale for this is explained through the matching principle in accounting: that a business should be able to assign expenses to the revenue for which they were incurred, recording them during the appropriate period. (More on this in a moment.)
As with capital assets the costs of non-tangible assets such as a software license may typically be written off over the period during which it will contribute to the generation of revenue, though there are some important differences. For example, usually the operational expenses may not be written off over a period that extends beyond their (let’s call it) lease period. Though some of the articles I have read have suggested that amortization is financial jiggery-pokery (“capitalizing opex”) it is not and I believe it makes a lot of sense.
For example, suppose you have a three-year contract with a specific vendor for your desktop OS, mail server, development environments, and the like, that has a multi-million-dollar price tag (not atypical for a large enterprise). You are billed annually on January 1st for one-third of the amount (e.g.: $2 million). Were there no allowance for amortization you would pay the entire amount January 1st and take a major hit to your Q1 (in fact, January) expense line. That would not be an accurate accounting of things since that license would be consumed over twelve months, contributing to revenue the entire time. To account for that, those costs may be amortized across the period over which they contribute to the generation of revenue. (In my experience the amortization cannot exceed the lease/usage period.)
In the end, it’s no different than renting an office where someone pays by the month. They expense each month of rent against the revenue for that month.
In contrast, imagine if this were not possible. In a worst case everything of this nature might need to be expensed in the first month of a fiscal year (e.g: when the bills were paid). This would make for a tremendous bottom line benefit over the final 11 months with very little expense, if the company were allowed to survive past the first month. Were this the case, regardless of the month of acquisition it would be a much less accurate reflection of the monthly operating costs of the business.
Cash Flow and Budgeting Remain Critical
That all sounds nice and clean, though one must also be conscious of cash flow, which is a different beast. You need the cash when the bill is due, so planning when the bills are to be paid, and when assets are acquired and expenses are incurred, is of critical importance. You cannot spend what you do not have. In my role as a private cloud provider I spent a lot of time every year carefully planning when money would be spent on assets and expenses. Cash flow is critical, and we also had to ensure that we planned things so that assets arrived before our consumers needed them and that the team’s work was scheduled such that they had the capacity to receive and provision new assets.
Capitalization of operating expenses and the subsequent amortization over the course of use do not remove the need for disciplined budgeting, cash flow, and deployment planning. If anything, they become even more important. Our fiscal year began April 1st and we started talking about our budget at a high level in August. We prepared straw man budgets in September, made a first pass with decent detail in October (ready for Finance and stakeholder consumption), and fine tuned it and made adjustments from November through February. All the while working very closely with our Finance team and our stakeholders.
A Tale of Two Write-Downs
So capitalization and amortization are inter-related. Certainly with a capital expense there is something tangible that is owned, and it may have some value on its disposal; though it may not. Operational expenses such as leases may have no value at all outside the context for which they were incurred (e.g.: if I decide to opt out one year into a three-year rental agreement, I may not be able to sublease in order to recover value, and I may still need to pay for the entire term.)
For accountants and finance pros, there are not any stunning revelations here, though hopefully it all makes sense, particularly to the rest of us. Though, what about the magic of capitalizing opex? I believe that is the semantic issue I referred to at the outset. We are really having a debate about a technical term versus something said to illustrate a point. I would bet it’s amortization. And really, does it matter what we call it when we’re trying to help one another? (If you are a CPA and you are filing financial records, OK, it matters.)
Partner with Those Who Know
Is it always that simple? Of course not. That’s why a partnership with your Finance team is critical. They have all of the technical knowledge required to make the most efficient, legal, compliant decisions regarding these things. Though regulations regarding these things can be similar in different regions they can also be different, as can the limits under and over which certain assets and expenses may be treated differently, so diligence is required.
There are also many other considerations such as your company’s policies, which may be far stricter than the regulations, and handling operational expenses which have a term that crosses fiscal year boundaries. As well, care is required in crafting contracts for those assets and expenses. It may or may not be possible for you to amortize “potential capacity” or other operational expenses; and incorrect wording in a contract may change how an asset or expense can be handled. Imagine putting your company in a position where that $2 million expense cannot be amortized.
So work with your Finance team and they will help you to gain the maximum benefit from amortization and capitalization legally while respecting your company policies. After all, Jeffrey Skilling has all the company he needs.
Calculator image courtesy of stock.exchg.
Originally Published: March 24, 2011