How to Account for Contract Costs Under the New Revenue Recognition Standard
Much of the attention for FASB’s new revenue recognition standard for contracts with customers, ASC 606, has focused on the revenue side. I’ve written about that here, but ASC 606 also includes the subtopic, ASC 340-40, which specifies how companies should account for and recognize the costs associated with those contracts.
As a part of ASC 606, this guidance is effective for public companies for periods starting after Dec. 15, 2017. Non-public companies get an extra year and must implement this for periods after Dec. 15, 2018.
What’s Excluded From ASC 340-40
As part of ASC 606, this new guidance applies to all businesses with customer contracts with the exceptions of leases, insurance, guarantees and some non-monetary exchanges, for which separate guidance exists.
ASC 340-40 covers costs that aren’t covered under specific guidance, so it doesn’t apply to the following types of costs, which have their own guidance:
- Inventory (ASC 330)
- Preproduction costs for long-term supply contracts (ASC 340-10)
- Property, plant and equipment (ASC 360)
- Certain advertising expenses (ASC 720)
- Offering costs for investment companies (ASC 946-720)
- Costs of software to be sold, leased or otherwise marketed (ASC 985-20)
Companies should follow the relevant guidance for these areas.
A Three-Prong Test for Capitalization
For all other contract costs, companies need to evaluate the costs in terms of the following three criteria. In general, if all three are met, capitalization is mandatory:
- Incremental costs directly related to a specific contract
- Costs that generate or enhance resources of the company that will be used to satisfy performance of the terms of the contract
- Costs that are expected to be recovered from the customer
This means that many companies will be capitalizing contract costs that they had previously expensed, so they may see an increase to net income.
Here’s a test to distinguish the incremental contract costs – which must be capitalized – from other costs that can be expensed: If all parties walked away from the agreement just prior to the final signing, would that cost still have been incurred?
For example, sales commissions related to a specific contract are capitalized, but travel expenses for sales personnel to pitch to a new customer can be expensed. Likewise, the legal expenses to draft the agreement can be expensed. Those expenses would have been incurred even if the contract is rejected. Bonuses tied to the company’s overall performance, and not to a specific contract, are expensed.
What Costs Need to be Amortized?
Here are some general examples of the kinds of costs that need to be amortized:
- Direct labor to provide the goods or services in the contract
- Direct materials or supplies
- Allocated costs that relate directly to the contract or to contract administration
- Costs chargeable to the customer under the contract
- Other costs incurred specifically for servicing the contract
How Should Costs be Amortized?
Capitalized costs are amortized over the period that the services are expected to be delivered to the customer. This means that companies may need to include likely renewal periods in the amortization period.
For example, if the original contract is for a single year, but experience shows that on average, customers retain the company’s services for a total of three years, then three years may be an appropriate amortization period. Determining the amortization period will require judgment, especially for contracts that are renewed many times. The goods and services provided after ten or fifteen years of repeated renewals may bear little relation to those provided in the first year or two, so a shorter amortization period may make more sense.
This may also mean that contract costs are amortized over a longer period than the period over which revenue is recognized. As a practical expedient, if the amortization period is one year or less, the costs can be expensed as incurred.
The method of amortization should be consistent with the timing of the transfer of goods and services to customers. For example, if services are provided evenly over the contract period, the costs should be amortized on a straight-line basis.
Over time, the carrying amount of the contract costs may become impaired. This happens when the unamortized costs are greater than the remaining consideration to be received minus the future costs to be incurred. In this situation, the company will recognize an impairment loss.
This new guidance represents a big change from the ways companies used to account for contract costs, so it will take time and effort for advisors to fully understand the nuances for your clients.