Pitfalls and Hacks in Cloud Project Budgeting and Accounting
Meet the Experts
⇨ Proper Cost Classification: Understanding the run and build categorization of IT expenses is crucial for accurate budgeting.
⇨ Capitalization Considerations: When embarking on a cloud project, it's essential to identify which costs can be capitalized or accumulated over time.
⇨ Optimization potential: Gain valuable insights and practical strategies to avoid common pitfalls, effectively allocate resources, mitigate risks, and maximize the benefits of cloud projects in terms of budgeting and accounting.
The Very basics
The picture below shows the typical budgeting and accounting aspects of an IT cloud project over time. Prior to the project, there is the existing IT budget. During the project, there is the project budget, which may draw from the “build” budget. Once the project is completed, the asset created during the project depreciates over time. These concepts will be explained in further detail below.
Run and Build View on the IT Budget
The “run and build” framework categorizes IT expenses based on their purpose, allowing organizations to allocate resources and prioritize investments effectively.
- Run Category: This includes ongoing expenses for IT system maintenance and operation, such as hardware and software maintenance, system monitoring, and user support. It ensures smooth operations and uninterrupted business functioning.
- Build Category: This covers expenses related to developing and implementing new IT systems, including software development, hardware procurement, and project management. It helps organizations expand their business, introduce new products/services, and foster growth and innovation.
By understanding these categories, organizations can strategically manage their IT budgets, balance maintenance and development needs, and achieve their strategic goals.
The Project Investment
An IT project can build an asset when it results in the creation of an intangible or tangible asset that provides economic benefits to the organization over a period. A cloud project will obviously create an intangible asset with no physical substance, but it can provide economic benefits to the organization by enhancing its reputation, increasing its market share, or improving its ability to generate revenue.
There are generally three main phases of financial treatment for an asset: accumulation, capitalization, and depreciation.
- Accumulation refers to the initial process of acquiring an asset. This could involve purchasing a new piece of equipment, building a new structure, or acquiring a new investment property.
- Capitalization is the process of recording the cost of the asset on the balance sheet as a capital asset, which is then depreciated over time. This involves taking the total cost of the asset and spreading it out over the asset’s useful life. The useful life is the estimated period over which the asset will provide benefits, and depreciation expense is recorded each year to reflect the decrease in value of the asset over time.
- Depreciation is the process of allocating the cost of a capital asset over its useful life. This means that a portion of the cost of the asset is deducted from the company’s income each year as a non-cash expense. This reduces the company’s taxable income and helps to offset the initial cost of acquiring the asset.
Watch out: In an IT project, certain project costs may not be allowed to be capitalized or accumulated. (see below)
Project Parts be Capitalized
In an IT project, certain project costs may be allowed to be capitalized or accumulated. These costs are typically considered to be expenses related to the development of new IT assets and provide economic benefits to the organization over a period of time. Examples of project costs that may be allowed to be capitalized or accumulated include:
- Software development costs – These are costs associated with the development of new software applications or the customization of existing software to meet the needs of the organization. These costs may include salaries of software developers, project management costs, and the cost of software licenses or tools.
- Hardware costs – These are costs associated with the purchase of new hardware to support the IT project, such as servers, storage devices, or network infrastructure.
- Direct labor costs – These are costs associated with the time spent by employees directly involved in the IT project, such as software developers or project managers.
- External consulting fees – These are fees paid to external consultants or contractors to provide expertise or services related to the IT project, such as software customization or system integration.
- Testing and validation costs – These are costs associated with testing and validating new IT systems or applications, including the cost of testing tools, salaries of testing personnel, and project management costs.
By properly identifying and accounting for these costs, organizations can more accurately reflect the costs and benefits of their IT investments on their financial statements. Capitalizing or accumulating these costs over time can also provide a more accurate picture of the long-term economic benefits of the IT project.
Project Parts not to be Capitalized
In an IT project, certain project costs may not be allowed to be capitalized or accumulated. These costs are typically considered to be expenses related to ongoing operations rather than the development of new IT assets. Examples of project costs that may not be allowed to be capitalized or accumulated include:
- Training and support costs – These are costs associated with training end-users or providing ongoing support for software applications or IT systems. Since these costs are not directly related to the development of new IT assets, they are typically considered operational costs and are not eligible for capitalization.
- Data conversion costs – These are costs associated with converting data from legacy systems to new IT systems. While data conversion is a necessary component of IT projects, these costs are typically considered to be expenses related to ongoing operations rather than the development of new IT assets.
- Maintenance costs – These are ongoing costs associated with the maintenance and upkeep of IT systems, including hardware and software maintenance, system monitoring, and user support. Since these costs are not directly related to the development of new IT assets, they are typically considered operational costs and are not eligible for capitalization.
- Overhead costs – These are indirect costs associated with IT projects, such as administrative overhead or general operating expenses. Since these costs are not directly related to the development of new IT assets, they are typically considered operational costs and are not eligible for capitalization.
- Properly identifying and accounting for these costs is essential for accurate budgeting and financial reporting in IT projects. By distinguishing between project costs that are eligible for capitalization and those that are not, organizations can ensure that their financial statements accurately reflect the costs and benefits of their IT investments.
Cash out and controlling (profit & loss) view
The cash flow view refers to a financial perspective that focuses on the inflow and outflow of cash within an organization. It is concerned with the timing and amount of cash receipts and payments associated with an IT project.
The controlling view, on the other hand, refers to a financial perspective that focuses on profitability. By building the project asset, it is possible to finance the entire project through future savings, as is the case in this example. The accumulated value is not shown in the P&L during accumulation, and the depreciation is part of the IT budget but is lower than the savings. As a result, despite the high project volume, it does not appear on the P&L bottom line.
Cloud Pricing Structure
To explain the cloud pricing structure, it’s helpful to compare it to on-premise costing. Organizations can choose to make or buy different IT layers, ranging from owning their own data centers to renting systems or hosting entire systems. In on-premise costing, organizations typically own the licenses and pay maintenance fees to software producers. An operation-cost-oriented model based on supplier expenses plus a markup is also common.
In contrast to the on-premise world, there is no make option. Cloud and SaaS pricing are value-driven. The question becomes, “How much are you willing to pay for this function?” It doesn’t depend on the supplier’s operating costs but instead on market demand. Cloud pricing can be based on user numbers, storage usage, turnover, data traffic, and other factors. Therefore, it’s crucial to choose wisely before embarking on a cloud project.
Hacks and Pitfalls
Your freedom in the IFRS frame
IFRS (International Financial Reporting Standards) is a globally recognized set of accounting standards that provides guidance on financial reporting for businesses. It aims to ensure transparency, comparability, and consistency in financial statements across different countries and industries. IFRS IAS 38 refers to the International Financial Reporting Standards (IFRS) and International Accounting Standard (IAS) 38, which provides guidance on the accounting treatment for intangible assets.
Capitalization of cloud run fees during the project runtime
The capitalization of cloud run fees during the project runtime is contingent upon specific circumstances and accounting regulations. In general, according to the International Financial Reporting Standards (IFRS), expenses related to the ongoing operation and maintenance of IT systems, including cloud run fees, are classified as operating expenses and are not typically eligible for capitalization.
However, it is advisable to consult with your accountants to explore the possibility of treating these fees as infrastructure procurement costs. In many cases, these services are operational during the project ramp-up phase without being fully utilized in production. As such, they can be considered integral to the project’s investment and asset development.
SaaS projects: The elusive quest for intangible asset qualification.
On April 27, 2021, the IFRS published a document addressing a request received by the Committee regarding the accounting treatment of costs associated with configuring or customizing a supplier’s application software in a Software as a Service (SaaS) arrangement. This document brought about a significant shift in the treatment of intangible assets within the SaaS environment, altering the traditional perspective.
The chapter “Project parts be capitalized” simply does not apply as it does not grant the customer ownership of the software as an asset. Instead, it is considered a service provided to the customer throughout the contract. In general, the accounting treatment of costs associated with configuring or customizing a supplier’s application software in a Software as a Service (SaaS) arrangement does not involve accumulation, capitalization, or depreciation. This means that the customer does not typically recognize these costs as assets on their balance sheet. Instead, the costs are considered expenses incurred for the service received over the duration of the contract.
However, there is an exception to this rule. If the service of configuring or customizing the supplier’s application software is performed by the supplier itself and meets certain criteria, it may be eligible for capitalization. This means that in specific cases where the supplier’s activities result in the creation of a distinct and identifiable asset that provides future economic benefits, the related costs can be recognized as an intangible asset on the customer’s balance sheet.
Private Cloud: Ensuring Feasibility for Transfer to an On-Premises Environment
Despite the cloud-based nature of your contracts and project setup, it is important to recognize that the previously mentioned framework may not be directly applicable in this specific scenario. However, the key leverage point lies in presenting a compelling argument and showcasing the proven feasibility of transferring the developed solution to an on-premise environment. The question of economic sense becomes secondary; the true essence lies in determining whether you genuinely own the equivalent value created, independent from the supplier. Once the ownership aspect is confirmed, you can confidently proceed with cost analysis and investment decisions, treating the project as you would any other on-premise software initiative.
Overcoming Licensing and Run-Fees Challenges
During the implementation project, achieving accuracy in licensing and run-fees can be a daunting task. It often leads to situations where you find yourself either over or under licensed in various aspects. Users may need certain services while others may not, and the transition phase involves working with multiple systems. Without proper measures in place, it’s easy to feel lost in the complexities.
To mitigate these challenges, it is crucial to negotiate the following points into your contracts:
- Audit Holiday: Consider including provisions for an “audit holiday” that allows for a defined period during which audit requests are temporarily suspended. This can provide a sense of relief and alleviate the burden of audits during critical project stages.
- Pause and Termination: Define clear scenarios and conditions for pausing or terminating the project. Having well-defined termination clauses minimizes potential losses and ensures a smoother transition if unforeseen circumstances arise.
- Swap-Rights: Incorporate swap-rights provisions into the contract to mitigate risks associated with shelf-ware or overuse. These rights provide flexibility, enabling you to adapt and make necessary changes to align with evolving needs.
- Forward Discounts: Optimize your cost savings by negotiating forward discounts. Consider purchasing the minimum required user-types or services with the potential for future interest, securing the maximum possible rebate. This approach ensures price predictability and eliminates the need for extensive renegotiations when upscaling or switching.
Embrace the fact that cloud implementation is a substantial investment with inherent risks on your side, while the supplier carries a relatively lower risk. By proactively considering and negotiating these contract provisions, you can safeguard your interests and play it safe in this dynamic landscape. Remember, there’s no need to hesitate when it comes to securing your investment and ensuring a successful cloud journey.
Unlocking Benefits through Legacy System Investment
Contrary to common belief, there are several ways to gain significant benefits by investing in your legacy system. During the project, this investment can serve as a means of capitalization by pre-building functions within the existing infrastructure. Consider the following examples:
- Streamline Authorizations: Establish a well-defined governance model and assign governance roles to individuals. By completing 80% of the necessary work, the organization learns valuable lessons for the new system. Reduce day-to-day super-power-user access and limit system users to the bare minimum. With this streamlined approach, you can sleep better knowing that only 20% of users require attention while satisfying auditors’ requirements.
- Transition Outside Interfaces: Gradually migrate interfaces to the new environment, starting with external interfaces. Some external parties may struggle to move away from file transfers, full loads, and IDocs. However, many will be eager to collaborate with you using modern communication methods such as APIs, XML, JSON, and encrypted channels.
- Embrace Fiori and Other Apps: Begin integrating Fiori and other applications into your legacy SAP system. This enables the IT department to become familiar with the modern application landscape while offering users a glimpse into the benefits of a more contemporary user experience.
- Documentation and System Change Management: Emphasize the importance of proper documentation and system change management from the project’s inception. Ensure that system changes align with clear requirements, undergo rigorous testing, and are documented in a manner understandable by a knowledgeable third party. Utilize computer-based tools like JIRA, Confluence, and ChaRM to maintain cleanliness and organization in your new systems from the outset.
- Patch Satellite Systems: Consider upgrading and patching satellite systems, such as Warehouse, Document, and Shop-Floor systems, to the latest versions. Integrating these systems within your regular patch cycles ensures they align with the drumbeat of updates and stay in sync with your primary infrastructure.
Reflect on your previous projects and recognize that investing in your legacy system is an inevitability. By addressing it early on, you can avoid last-minute rushes and ensure that the process is executed efficiently and effectively. Approach the investment with diligence and foresight and reap the benefits throughout the entire duration of the project.
Cloud project budgeting and accounting require careful consideration and planning to avoid common pitfalls and leverage effective strategies. By understanding the run and build view of IT expenses, organizations can prioritize investments and achieve strategic goals. Identifying which costs can be capitalized or accumulated provides a more accurate financial representation of the project’s benefits over time. Additionally, contract negotiation and risk mitigation play a vital role in safeguarding investments and ensuring successful implementation. With these insights, organizations can navigate cloud projects with greater confidence, optimize resource allocation, and maximize the return on their IT investments.