Q: As initially written, Financial Accounting Standard 13 excluded many intangibles, including software. However, with SOP 98-1, software has been reclassified as an asset, and one that must be (if material) capitalized upon acquisition.
What are your thoughts about structuring large software financings under FAS 13 to allow for off-balance-sheet treatment?
San Bruno, Calif.
Let us first say that regardless of how the following answer may come out, the answer included herein is the opinion of the writer and not of the company he works for or of the organization to which he is affiliated, or, for that matter, of CFO.com. With that disclaimer, we can speak freely about the background of software leasing and the applicability of it relative to capitalization of software.
I would say that not only can software be leased, but that software can be leased under an operating lease. However, accountants should exercise caution when examining a software lease and consider the reasons why a lessor would write such a lease and whether these reasons provide the accountant with reasons to classify the lease as a capital lease.
The preface of FAS 13 defines a lease as “an agreement conveying the right to use property, plant or equipment (land or depreciable assets or both) usually for a stated period of time.”
FAS 13 was meant primarily as an economic depiction of the substantial risks of ownership. Basically a lessee was to record as an asset anything which they had substantial risks of ownership, as defined in paragraph 7:
This raises several important questions:
Can software be considered an asset which can be ‘leased’?
While software was not so widely considered at the time the original FAS 13 was written, the nature of what constitutes an asset has changed over the years, hence the idea that software costs can be capitalized as a fixed asset and depreciated over time, because its value is recoverable and useable over an extended period. Under the ‘matching principle’, we attempt to match revenues with the expenses incurred to generate or support the generation of those revenues. Hence, current accounting opinion has concluded that much software falls under the category of an asset that can be capitalized and depreciated.
Hence, I would conclude that software can be leased, subject to the other conceptual rules and guidelines of FAS 13.
Does a lessor maintain the ‘right to use’ the asset which can be conveyed to a lessee?
The right to use an asset was generally considered to exist because a company had the legal title to the asset and thus legally could restrict the use of the asset or provide for the right to use the asset. FAS 13 actually redefined this concept into an economic structure — that is, the right to use an asset can be defined in economic terms rather than legal terms which hinged on title and ownership.
The overlaying of a financing which restricts the right to use the asset, for instance if a lessee fails to make payments when due, seems sufficient to qualify the asset for a lease based on this conceptual requirement. Thus, one could control the right to use an asset such as software without actually owning it or ever having the legal right to own it, or for that matter, remarket it.
Does a lessee automatically have an economic compulsion to renew or make a final payment to acquire the permanent rights to use the software?
Replacing software may not be as easily accomplished as replacing some other assets, because the installation timeframe and effort may be great. This is not to say that software once installed is never replaced. In fact, we see that software is indeed replaced more frequently.
Just look at the market capitalization of the two largest software vendors, Microsoft Corp. and Oracle Corp. Both have clearly demonstrated that there is a market for newer and better software all the time.
For this reason we can conclude that perhaps there is not an economic compulsion for a lessee to renew.
Why then would a lessor take the ‘bet’ that the lessee would actually renew the software lease? One answer to this may be the difference in opinion between a lessor and lessee. For instance, a lessor may lease with the belief that a lessee will retain the software installation. The lessee one the other hand may not be sure and would rather pay as little for the software license as possible. An analogy can be drawn to the leasing of personal computers (PCs). Any knowledgeable person realizes that the value of a PC is negligible after 36 months, and yet lessors continue to lease them, perhaps because lessors have figured out how the value is derived from leasing PCs. Similarly, software lessors would be willing to play the odds to make their profits.
Thus, I would conclude that software indeed can be leased.
Can a software lease pass the FAS 13 operating lease tests?
The next question we have is whether it can be leased under an operating lease? Obviously in order for a lease of software to qualify as an operating lease, it must pass the numerous tests described above.
We believe that all of such tests articulated above can be passed, including test “D” described above.
While it may be difficult for most of us to think that lessors would be willing to take the risk that a lessee of software would renew, we do find some lessors who will indeed take this risk.
A lessor may be placing a bet on the preponderance of renewal activity with respect to an overall portfolio and while estimating the probability of this occurring on an individual basis may be difficult, overall the lessor may arrive at the correct conclusion. Nonetheless, on an individual basis it would appear that no lessor would willingly write such leases if they actually believed that an individual lessee would actually return the software.
We should point out that some software vendors have provided structural vehicles which make leasing software more palatable to the lessor, including an ability to ‘switch off’ the software if the lease were not paid.
In conclusion I would say that not only can software be leased, but that software can be leased under an operating lease.
However, I would caution any accountant when examining a software lease to look closely at the reasons why a lessor would write such a lease and consider whether these reasons provide the accountant with reasons to classify the lease as a capital lease. Still, since many business decisions involve different opinions on the same facts and circumstances, the very existence of such a difference is not cause to disallow operating lease treatment.
Joe Sebik, CPA
Vice President, J.P. Morgan Leasing
Member, Equipment Leasing Associations Accounting Committee
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