Is the Cloud on a Collision Course With Your Balance Sheet?

Companies are moving at a rapid clip toward adopting cloud computing processes, including infrastructure-as-a-service (IaaS), which allows them to outsource their IT departments to third parties. IaaS frees companies from buying and maintaining servers for applications, storage, and networking and from recording these servers on their balance sheets. Gartner predicts that the worldwide IaaS market will grow from $3.7 billion this year to $10.5 billion by 2014. But some say new lease accounting rules could dampen companies’ enthusiasm for hosting their data in the cloud, particularly on dedicated servers that these companies hope will afford them greater privacy and security.

The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have recently revealed some details of their second exposure draft on lease accounting rules, including their commitment to a “right-of-use” model that will require companies to capitalize many of the leases they currently can keep off their balance sheets. The boards haven’t specifically mentioned cloud computing yet, but the ramifications of the new leasing rule could have a significant impact on the IaaS market…

What the Boards Are Saying
The boards have said that the equipment portion of a service contract, such as a server, would be considered a lease if the equipment is identified in the contract, controlled by the lessee (for the lessees’ “direct use” and “benefit”), and central to performing the service. In practice, this could mean that if a company has its data hosted by an IaaS provider on a dedicated server – –  a server that can only be used by that company – –  it could be required to account for that server as an asset and a liability on its balance sheet. This change would make the company appear more highly leveraged than before, and could, in turn, make it less attractive to investors. If the company could not separate the lease of the server from the contract’s service components (such as automatic upgrades or patches to the software), it would be required to record the whole cost of the contract on its balance sheet.

Potential Consequences
If IaaS service contracts are included in the scope of the final lease accounting standard, companies may have a hard time estimating the cost of the servers involved in their contracts, says Bill Bosco, a member of an IASB working group that provides input to the boards. But Bosco says the boards are aware of the ruling’s possible negative implications. “[FASB and IASB] have recognized that if they make [the rules] too tight, there may be an awful lot of assets that come on balance sheets that will come on as estimates, and [valuing them] will be extremely complicated,” he says, predicting that the boards may consider fewer contracts to be leases than they do currently.  

Indeed, if cloud service contracts fall outside the scope of the lease standard, more companies may move toward the cloud, says John Hepp, a consultant at Grant Thornton. Owning the servers means they’re going to show up on the company’s balance sheet, Hepp says, adding “I don’t think cloud servers necessarily will.” Still, “there may be some judgment involved,” he says. “If I have exclusive right to control the use of specified assets then, under the leasing project, it could go on the books for a server. But I think that might be very rare.”

The boards plan to release a revised draft of the rules early next year.