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11/06/2024
Digital, News, Insights

Guidance on the financial implications of cloud transformations to save public services time and money

Based on our experience supporting public service leaders with their cloud transformations, we have compiled the most frequently asked questions regarding the financial and accounting implications of successful transitions to the cloud.

Public services are under considerable strain and face unprecedented pressure to reduce costs, reassess how services are delivered and improve the delivery of services. Public service organisations are increasingly turning to cloud computing as a key component of their digital strategies to meet these demands [1]. Once an organisation has committed to a transition to cloud computing, leaders encounter an often tricky question: what are the financial and accounting implications of a transition to the cloud, and how do we manage these?

Guidance on the financial implications of cloud transformations to save public services time and money

As we see a greater shift away from traditional IT infrastructures towards cloud-based compute and storage, it is key for strategic and IT leads to work closely with financial and accounting teams to make sure the intricacies of the financial implications of cloud technology are fully understood. This is critical in order to develop robust business cases, procure the right solutions for your organisation, finance the investments and manage the transition to the cloud. Despite the numerous opportunities cloud computing presents, it remains a relatively new domain for many finance teams, and its complexities can pose significant challenges.

This article provides a high-level overview of key financial and accounting implications of a transition to the cloud, offering insights and practical guidance to help effectively manage this journey. We have compiled the most frequently asked questions we have helped clients answer into this article:

  1. What are the main financial differences with cloud computing?
  2. What is the difference between capital and revenue in the IT setting, and why does it matter?
  3. When can cloud computing be recognised as capital, and what are the implications of this?
  4. When is cloud computing expenditure recognised as a revenue expense?
  5. What can organisations do to manage the shift from capital- to revenue-intensive expenditure?
  6. How can I learn more as our team considers or embarks our transition to the cloud?

1. What are the main financial differences with cloud computing?

Cloud computing is a broad term used to describe technology that allows organisations and individuals to access and store data, applications, and services over the internet rather than on local servers or personal computers [1]. There are a wealth of benefits offered by cloud computing, and importantly there are a couple of key financial implications to be aware of:

  • Transition from predictable to pay-as-you-go: In traditional IT infrastructure, computing and storage costs are predictable and fixed, with upfront purchases and easy cost tracking. In contrast, cloud computing uses a pay-as-you-go model with limited (if any) upfront payments. This allows organisations to make use of the latest technology and services as soon as they are available and alter technical architecture quickly if strategic needs change. This can also save money, however it can lead to fluctuating expenses based on consumption and can be harder to predict.
  • Perceived lack of control: Despite offering increased flexibility and scalability, cloud computing can cause concerns about maintaining control compared to traditional IT infrastructure due  risk of supplier lock-in and future pricing uncertainties.
  • Shift from capital-intensive to revenue-based expenditures: Traditional IT infrastructure typically involves building tangible assets, whereas cloud computing focuses on either intangible assets or in many cases service payments (Iaas, PaaS, SaaS). This shift is especially impactful in public sector funding models, where there can in some cases remain a perceived difference in the attractiveness of capital compared to revenue. 

Of these three, often the final point concerning the transition from capital to more revenue based models can be the most challenging and complex to navigate.

2. What is the difference between capital and revenue in the IT setting, and why does it matter?

There are quite distinct differences between capital and revenue expenditure, and there are strict definitions and guidelines within public service organisations as to how things should be recognised. In traditional IT projects the distinction between capital and revenue are often clear, as you can clearly distinguish between a cost contributing to a tangible asset or being a day-to-day operational expenditure. Now with cloud computing these lines are more blurred. The key International Financial Reporting Standards (IFRS) standards which relate to this are:

  • IAS 38 Intangible Assets [2]
  • IAS 16 Property, Plant and Equipment [3]
  • IFRS 16 Leases [4]

The table below draws out the key differences between capital and revenue expenditure [5]:

It is important to get the categorisation of expenditure correct for multiple reasons:

  • Some projects have a split in funding between capital and revenue and often business cases will need to demonstrate that they can satisfy these constraints
  • As outlined above, the accounting treatment for capital and revenue is different, including whether depreciation/amortisation applies. Likewise, the VAT treatment differs between capital and revenue expenditure
  • Many public sector organisations have a CDEL and RDEL (capital / revenue department expenditure limit) which has been set by the central government. To ensure that organisations are within these limits expenditure has to be accurately recorded

3. When can cloud computing be recognised as capital, and what are the implications of this?

Upon first inspection, it certainly seems that cloud computing is predominantly revenue, however there are some cases where cloud expenditure can be capitalised. If you can evidence that [2, 6]:

  • Expenditure contributes towards an intangible asset [2] - an identifiable non-monetary asset without physical substance which the organisation then has full ownership over and responsibility for
  • It is probable that there will be future long-term economic benefits from the asset 
  • The cost of the asset can be reliable measured - the cost that can be capitalised is the cost that needs to occur  to bring the asset to a usable condition

If you are able to evidence all 3 points above, then it can be argued that this is capital expenditure. In this case, there are some key accounting implications you will need to be aware off:

  • Amortisation - an intangible asset is amortised over the useful life of the asset. You can think of amortisation as depreciation but for intangible assets, and is seen as a way of spreading the cost of an asset. Amortisation is usually charged on a straight line basis over the lifetime of the asset, and begins when the asset is available for use [2, 8]. 
  • Useful life - There are many factors which influence the useful life of an asset, including the expected usage of the asset, the stability of the industry in which the asset operates and typical product life cycles. For intangible technology assets the useful life is often relatively short - in our experience, 5-years is often a good starting point [2]. 
  • Public dividend capital (PDC) - For most capital expenditure within NHS organisations, organisations will need to pay a PDC dividend to DHSC. Currently the dividend rate is fixed at 3.5% of the net relevant assets (a measure of how much the NHS trust owns) and shows on the income statement as an expense [7]. 

While there are some definite benefits of using capital to pay for cloud computing, there are certainly also some drawbacks to consider; capital expenditure requires ongoing accounting treatment and reporting, and is often subject to more scrutiny from governance bodies, particularly considering CDEL. If the asset is acquired through a long-term contract or licence, there is a risk of vendor lock-in. As such, it is important to consider the alternative revenue expenditure [1]. 

4. When is cloud computing expenditure recognised as a revenue expense?

It is relatively straightforward: expenditure is recognised as an expense whenever it is not capital expenditure as outlined above. 

Some examples of revenue expenditure include [5]:

  • Items which require a subscription fee, such as software licences (non-ownership) or cloud-based services such as SaaS when paid on a subscription basis 
  • Web hosting 
  • IT infrastructure maintenance
  • Regular software / cloud support 

And the accounting for revenue expenses is much more straightforward too: it is reflected directly in the statement of comprehensive income as an expense. 

However, there are some challenges with cloud computing revenue expenditure. When operating a pay-as-you-go model which is so common with cloud-computing, it can be unpredictable how costs will vary from month to month and therefore hard to plan for. Similarly, cost visibility is much more difficult; it can be hard to identify what is driving the variation in costs and thus manage costs [5].

5. What can organisations do to manage the shift from capital- to revenue-intensive expenditure?

As organisations transition to cloud computing, it’s natural for much of the spending to shift from capital to revenue. While there are ways to mitigate this shift, and many cloud providers offer buying mechanisms that align spending patterns with typical capital budgets, it’s essential to recognise the limitations of this approach. Options like large up-front payments or pre-committing to multi-year usage can help with budgeting but reducing the technical flexibility and hinders cost optimisations which are some of the strongest selling points of cloud computing [9]. 

A more sustainable approach may involve, where possible, working with your finance team to reclassify capital expenditure budgets as revenue expenditure, allowing organisations to fully leverage the cloud’s full benefits including its flexibility and scalability [9]. 

6. When can I learn more as our team considers or embarks on our transition to the cloud?

At The PSC, we not only support organisations to help the financial implications of a cloud transformation - we provide expert advice tailored to your organisation’s needs to support you throughout your cloud journey, including:

  • Developing cloud strategies that are aligned with your organisational strategies, as well as the national direction of travel 
  • Authoring cloud business cases that meet your governance requirements while creating a compelling case for investment
  • Advising on the procurement and financial implications of an effective transition to cloud
  • Developing and implementing plans to increase cloud adoption to support a successful cloud transformation
  • Supporting the technical development and transition from traditional IT infrastructure to cloud-computing 

To discuss further and explore how we might support your organisation with your cloud transformation, please contact Dr Antonio Weiss (antonio.weiss@thepsc.co.uk) or Danny Silk (danny.silk@thepsc.co.uk).

 

Author: Emilie Olufsen

References

[1] CIPFA, Accounting for the Cloud
[2] IFRS, IAS 38 Intangible Assets, 2024 
[3] IFRS, IAS 16 Property, Plan and Equipment, 2024 
[4] IFRS, IFRS 16 Leases, 2024 
[5] CloudZero, CapEx Vs. OpEx In The Cloud: 10 Key Differences, 2023
[6] HFMA, Accounting for revenue and capital - Implications for the digital age, 2021
[7] HM Treasury, The Green Book Central Government Guidance on Appraisal and Evaluation, 2022
[8] HFMA, Introductory guide to NHS finance - Chapter 14: Capital funding, planning and accounting
[9] GOV.UK, Managing your spending in the cloud, 2021

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