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IT SaaS Projects: Capex and Opex

Written by: Richard Frykberg

Traditional software was acquired via perpetual license or developed internally. New systems are now being acquired under a ‘subscription’ license or fully hosted Software-as-a-Service (SaaS) agreement. In both cases, the investment of internal labor and external consulting fees to design and configure a SaaS model is significant. The challenge for financial controllers is how to budget effectively for these large Information Technology projects: should they be budgeted and accounted for as Capital Expenditure (Capex) or Operating Expenditure (Opex)?

Whilst the accounting treatment of a SaaS agreement will be impacted by the contractual form of the agreement, the substance of most SaaS projects is to establish a technology platform that delivers ongoing benefits. Thus, in an economic sense, most SaaS projects are capital by nature.

Best Practices guidance suggests that SaaS projects should therefore always be approved through your budgeting process and justified on a comparable basis to purchased or bespoke development. The appropriate cost to consider is both the up-front implementation services cost and the net present value of subscription fees over the planning horizon.

This blog will help you understand your SaaS projects, the accounting implications, and how to prepare a successful business case submission for a SaaS solution.

Understanding SaaS Agreements

Why are Software Providers Encouraging SaaS?

Software developers such as SAP and Microsoft are aggressively transitioning their solution delivery models from on-premises perpetual licensing to cloud subscriptions primarily to reduce the cost and accelerate the pace of solution delivery. There are many environmental dependencies when deploying on-premise solutions that require on-going administration including hardware platforms, operating system versions, database management systems, and third-party software components. As software ages and the underlying environments evolve, the number of supported versions and application landscapes increases geometrically. This limits SaaS vendor validation and support capacity, leading to slower and less ambitious version releases.

By contrast, with true multi-tenancy cloud-hosted SaaS solutions, the software manufacturer has complete control over nearly the entire technology stack. Of course, user access mechanisms rely on a compatible browser and any integrations still require careful API management, but all the other typical dependencies can be controlled. With only one version to support, software vendors can rebalance their team towards innovation and competitive differentiation, and more agile delivery cycles.

What’s Included in a SaaS Agreement?

The benefits to you the customer of a SaaS solution are plentiful. By acquiring software-as-a-service, your technical landscape complexity, responsibilities, and costs can be greatly reduced. You no longer have to cross-check the dependencies of any business application when considering your hardware and platform upgrades. You no longer have to retain support expertise in niche technology layers. You don’t need to worry about scalability, sustainability, and security of the solution. With modern SaaS projects you get all the benefits of the best-of-breed functionality provided without any of the headaches related to infrastructure provisioning, installation, implementation, or support.

Evaluating SaaS Projects

Investment Costs

Whilst SaaS solutions provide a wealth of functionality ready to be instantly adopted, in practice some degree of configuration is required. Classifications need to reflect your industry requirements. Workflow processes need to be tailored to your organizational responsibilities. Integrations need to be implemented to your other core systems. There are data migration costs in transitioning into a new solution. There is the cost of decommissioning legacy environments whilst preserving audit trails. Users will still need some degree of change management and training. Thus, whether you are transitioning from a legacy solution or digitally transforming for the first time, some significant implementation costs can be expected.

Is SaaS a Lease?

SaaS agreements may bear resemblances to equipment leases. In many cases, the agreements are intentionally framed to present as Opex costs. However, if substantively an arrangement transfers the risks and rewards of ownership to the lessor, the lease should be accounted for as a capital acquisition with a corresponding lease liability. For example, if the SaaS agreement is committed for a multi-year term, and on conclusion of which, a perpetual license to the software is transferred to the organization, then this may well simply be software acquisition presented as SaaS. If, however, there is no right to acquire perpetual license to the software, and licensing is renewable in perpetuity, then the agreement is likely a true operating expense (Opex).

Does Your SaaS Confer Controllable IP?

For SaaS implementation and customization costs to be reflected as an Asset, this investment must be the controllable property of the entity. The creation, ownership and protection of the intellectual property must be carefully assessed. Expenditure on training users is unlikely to qualify as an asset (even if future benefits are anticipated) and should be expensed when incurred. Thus, training is likely to be incurred regularly.

Once-off expenditure incurred on customized integration to existing systems where the control, risk and rewards of that integration accrue to the organization could qualify as an asset. In-between scenarios such as the tailoring of Workflows to accommodate the delegation of authority limits and responsible managers will be harder to assess. In general, however, the more standard the application of functionality, the more likely it is to be considered Opex. The more bespoke and specialized the development, the more likely it represents capital expenditure.

Implications of CapEx or OpEx for SaaS Projects

Accounting Implications

From an accounting perspective, the key difference between treating a solution as SaaS Capex or Opex is whether the expenditure is assigned to the balance sheet or income statement. This will impact the timing of the reflected expenditure in the results: either the implementation costs will be fully expensed up-front, or they will be capitalized and depreciated over the useful life of the solution.

Economic Implications

From a net present value perspective, the key difference is in the evaluation of the Tax Shield provided: if the up-front costs are required to be capitalized, then the value of the tax saving is reduced as the tax benefit is deferred to future periods.

Funding Source

From a financial perspective, the nature of the project will likely determine the funding source: either the capital budget or the departmental expense budget. Implementation of SaaS solutions such as S/4HANA or Salesforce.com are significant investments, and more likely to be considered ‘major projects’ and planned for as capital projects rather than operational expenditure.

Developing a Winning Business Case for SaaS Projects

SaaS solutions are currently the most generic form of digital enablement and transformation. However, there is still some lingering resistance to the adoption of a SaaS solution in organizations that have a strong tradition of ‘owning’ their capital base. As it is likely that your SaaS investment proposal will need to be progressed through your Capex management system and approval processes, the underlying concerns of management need to be explicitly addressed.

Software Planning Horizon

The reality is that your software application has a limited useful life and requires repeated re-investment to benefit from rapid technological advances, such as in artificial intelligence. Additionally, the skills required to support and enhance a unique SaaS application or legacy technologies rapidly dissipate. Indeed, the more bespoke the software application, the greater the liability to maintain the solution. Consequently, software investments seldom exceed a five-year planning horizon, and are often even shorter. With such short planning horizons, and such rapidly evolving technology, the argument for acquisition as opposed to simple adoption is extremely hard to make.

Identify Business Benefits

Like any investment, a SaaS solution needs to have clearly articulated business benefits. Software is needed for all the typical investment reasons: to achieve sustenance, savings, growth, compliance, environmental or strategic goals. Organizations running SAP, for example, are increasingly being incentivized to transition to the S/4HANA SaaS model, as SAP themselves pivot from an on-premises to a cloud SaaS provider.

Organizations that have long operated internal authentication, operating system and productivity apps from Microsoft are seeing the savings from adoption of their Azure and Office365 SaaS offering. Salesforce.com is now one of many SaaS-based CRM solutions to help organizations grow. A new breed of compliance and environmental management solutions are now on the market to address the unique challenges being presented to organizations as they look to meet their net-zero and sustainability goals.

What is the Urgency?

Sometimes the urgency for a SaaS solution is dictated by the current provider ending support of legacy software versions, which greatly increases the risk of not doing anything. The urgency for transition to SaaS is also being dictated by resourcing unavailability for legacy solutions. The strategic value of software, however, is increasingly motivating a new platform to address competitive demands. Organizations are simply unable to achieve the equivalent speed of innovation and depth of capability from bespoke software that they can realize from adopting broadly supported platforms, where the cost of platform development and support is shared by all participants, and with each organization still able to differentiate their processes through their unique configurations.

Have you Considered the Risks?

Naturally, a SaaS solution introduces its own risks. At the top of everyone’s mind is data security including confidentiality and accessibility. This is a valid concern. Nonetheless, a SaaS vendor is specialized in the provision and management of online software services. They have dedicated resources and platforms for ensuring that services remain secured and available. Indeed, any one organization would be unlikely to be able to offer the degree of governance and resilience of tier-1 SaaS company. When compared to the risks of internal platform and software version installation, administration, and support coverage, the inherent risk of a SaaS solution may indeed be lower than for internal deployment.

Is your SaaS Solution Strategically Aligned?

Ultimately, an organization needs to fulfill its strategic vision. The weight of investment will need to be in areas that support its unique differentiators. These may be in its people, products, or market positioning. For most organizations, this is unlikely to be in the operation of its underlying enterprise resource planning systems. So, where cost can be saved, and resilience gained through migration to best-of-breed SaaS solutions, more money can be invested in areas that will truly underpin an organization’s long-term success.

Effective Monitoring of Capex and Opex for SaaS Projects

All significant projects including SaaS software implementations are intended to deliver long-term benefits and are thus capital in nature. They consume substantial human and financial resources and need a robust business case to prioritize their inclusion in the project portfolio. Approval of these projects should be provided by senior management based on endorsement by IT, Finance, Procurement, and other impacted areas. All related costs should be budgeted and closely monitored.

Under certain criteria the installation costs and software components will require to be capitalized; in other cases, they may need to be expensed from an accounting perspective. However, irrespective of the accounting treatment, the budgeting, approval, execution and monitoring of the project is most related to your other significant capital projects and should be treated the same way.

Simultaneously, the customer experience and user-experience will improve by implementing optimal SaaS business practices. Modern Capex management systems such as Stratex Online will support the inclusion and effective monitoring of both Capex and Opex components of SaaS projects from a substantive and economic perspective to ensure your capital investments are optimized, no matter the form of software licensing adopted.