Author: Joyce Wong, Finance Manager (Chartered Accountant)
SaaS (Software as a service) subscriptions such as Microsoft 365 for email/collaboration, Xero for accounting, or even Vend for retail POS have become increasingly popular in today’s digital era. As too have cloud consumption models such as AWS, Azure and GCP.
While the benefits of SaaS subscriptions and Public Cloud Consumptions model have been well touted, there are also significant financial benefits associated including:
- Ease of cash flow due to monthly/annual subscription costs.
- No large initial cash outflow required resulting in more cash on hand that can be used across other capital projects with higher ROI or shorter Project Rate of Returns.
Historically SaaS subscriptions and cloud consumption have typically been treated as operating expenses thus reducing EBIT (Earnings before income tax). So while improving cash flow, there has been a traditionally negative impact on the bottom line.
However, in January 2018, “IFRS 16 Leases” was announced and with it comes some potential changes for all of us. Below provides a pragmatic perspective on the real impact that this change can have on your business.
First, by way of background, IFRS 16 Leases was issued by the IASB (International Accounting Standards Board) on 13 January 2016 and is effective for periods beginning on or after 1 January 2019, with earlier adoption permitted if IFRS 15 Revenue from Contracts with customers has also been applied.
The new Lease standards states that all leases are to be treated as a finance lease – with the exception of short-term leases less than 12 months; and when the underlying asset is of low value – less than $5k.
A lease asset and an equal lease liability will be shown on the balance sheet. Finance leases are essentially a loan. Repayments made will have an element of interest as well as principle and the lease asset is to be amortised over its useful life. This results in interest and amortisation expense, both which fall below EBITDA (earnings before interest, tax, depreciation and amortisation) and an improved EBITDA.
Under this change, both SaaS contracts and Public Cloud Consumption can be structured in a way to consist of a leased asset in which IFRS 16 will apply.
A contract contains a lease if it conveys the right to control the use of an identified asset over a period of time in exchange for consideration. This means the entity obtains substantially all of the economic benefits from the use of the asset and can use it as it pleases. The supplier cannot substitute the asset or impact how it is to be used.
How do you know if your SaaS subscription fits into the new lease model?
Eg. A software lease for $20,000 amortised over its useful life of 3 years with interest payments of $200 per month.
- During this time, you have the right to direct how, and for what purpose the software is to be used for.
- The SaaS supplier cannot impact how the software is used and cannot substitute it with another product from which it would benefit economically from the substitution.
- The software is an identifiable asset. You as the user have the right to substantially all of the economic benefit from the software throughout the 3 years.
- You have the right to use the software as you please.
- The supplier cannot impact how or for what purpose you use the software. Hence the contract contains a lease.
This lease will be treated as follows:
A right-of-use asset and an equal and opposite lease liability will be recognised on the balance sheet.
DR Leased asset $20,000
CR Lease liability $20,000
Interest expense and amortisation expense will be recognised on the P&L below EBITDA line.
Interest expense ($2,400)
Amortisation expense ($6,667)
This results in an increased EBITDA and a decreased operating cash flow due to a reduction in operating expenses. However, there is also an increase in debt and interest. This impacts gearing ratios and may trigger breaches of loan covenants eg. debt to equity ratios and interest cover ratios. This may also affect a stakeholders perception of a company.
Staff remuneration/bonus plans that are linked to EBIT or EBITDA will also be impacted. It is also important to note that the interest expense under IFRS 16 is a front-loaded lease expense which decreases over time, as opposed to the traditional straight-line expense.
While an increase in EBITDA is generally seen as a positive outcome, it is important to assess the overall effect on your business reporting.
A thorough review of financial metrics and impacts on the wider business should be undertaken to establish if the benefits outweigh the costs. If it does, structuring SaaS contracts and Public Cloud Consumption as a lease can be beneficial and is an option worth exploring.
If you’d like to discuss the ins and outs of this for your business, please don’t hesitate to get in touch and we’ll book in a coffee or a vino.
Disclaimer: This is an opinion piece and intended for information sharing. For Financial Advice you should consult your accounting or financial advisor.