Accounting for Software Leases

IFRS 16, the new Leasing standard and its application to subscription software purchases

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New accounting standard

A new accounting standard, IFRS (International Financial Reporting Standard) 16, becomes effective January 1, 2019 with significant implications for company’s lease accounting.

Under IFRS 16, all leases will be capitalized and reported as an asset with an offsetting lease liability on the balance sheet, eliminating reporting of off balance sheet leases that were reported as operating expense on the income statement.

These changes have a significant potential impact on the financial results and reporting of for organizations.

Software Licensing Trend

In the past, the perpetual software licensing model involved clients purchasing and owning a license to use the software in perpetuity. An upfront software fee was paid and capitalized on the balance sheet and an annual maintenance fee was incurred and expensed every year. For example, if a client purchased $1,000 of software licenses with a 20% annual maintenance fee ($200 per year), the $1,000 would be recorded as an asset on the balance sheet and $200 would be reported as operating expense on the income statement. If the software was expected to be used for 5 years, the company would incur and report $200 of amortization expense below the EBITDA (earnings before interest, depreciation and amortization) line every year. For example, if a company had $10,000 of revenue, it would have an EBITDA for the year of $9,800 and Net Income of $9,600.

Example: Traditional SaaS Model

Income Statement
Revenue $10,000
– Expenses -$200 (maintenance fee)
=EBITDA =$9,800
– Amortization $200
Net income $9,600
Balance Sheet
Asset Liability
Software fees – $1,000

Recently, a new subscription-based Software as a Service (SaaS) model has emerged in the software licensing industry where clients subscribe to a service that includes access to software, support and maintenance. Unlike the perpetual license, the SaaS model provides updates and support throughout the life of the subscription.

Although this model offers benefits to both customers and vendors, its major drawback is that all SaaS costs are treated as operating expense as they are incurred. Since the client no longer pays an upfront software licensing fee or annual maintenance fee, but instead, pays an annual subscription fee that includes access to the software and support, the entire subscription fee is expensed through the income statement as an operating expense.

Example: Subscription-based SaaS Model

Income Statement
Revenue $10,000
– Expenses -$1,000 (subscription fee)
=EBITDA =$9,000
Balance Sheet
Asset Liability

As shown in this example, companies will be faced with a significant reduction to EBITDA under this reporting.

IFRS 16 – the new lease standard

Under IFRS 16, companies capitalize all leases and report them on the balance sheet. A transaction is considered to be a lease if an underlying asset is explicitly or implicitly identified and the use of the asset is controlled by the client. A client controls the use of the identified asset by possessing the right to,

  • Obtain substantially all of the economic benefits from the use of such assets, and
  • Direct the use of the identified asset throughout the term of the lease.

With this in mind, software purchases can be customized to meet the definition specified under IFRS 16. Through a customized purchase agreement, the client can lease the software where they will be able to convert operating expenses above the EBITDA line to and interest and amortization expense below the EBITDA earnings line.

Application of IFRS 16 and Financial Impacts

To comply with IFRS 16, clients would account for the lease arrangement by recognizing a liability for the lease obligation on their balance sheet at the present value of the future lease payments over the lease term using the effective interest rate method) and an asset equal to that liability. The asset would then be amortized over the lease term leading to a reduction to operating. Both lease-related interest and amortization expense will be below the EBITDA line on the income statement.

Example: IFRS 16 & Financial Impacts

Income Statement
Revenue $10,000
– Expenses
=EBITDA =$10,000
– Interest $50
– Amortization $200
Net income $9,750
Balance Sheet
Asset Liability
Software lease $1,000 Software lease $1,000

Using amounts from previous examples, if a company recognizes an obligation for the software lease for $1,000 to be amortized over 5 years, with an interest expense of $50 a year, this would result in a EBITDA of $10,000 and a Net Income of $9,750. In this example, an asset and a liability of $1,000 is reported on the balance sheet to reflect our client’s lease obligation. On the income statement, EBITDA is not affected by the lease as the interest and amortization expense is reported below the EBITDA line.

EBITDA will improve as expenses decrease. It should also be noted that cash flow from operations will increase while cash flow from financing will decrease due to the increased lease obligation.

As 2018 nears, many Canadian companies have entered the earliest comparative period that will be presented in the year IFRS 16 is adopted. Speak with one of our experts about impacts and the implications of the new accounting standard.