In obtaining a contract, companies sometimes incur costs that would not have been incurred if the contract were not obtained. Many different costs can meet this definition; however, the most common example of this type of cost is a sales commission. Depending on the facts and circumstances, these incremental costs are sometimes recorded as assets and sometimes as expenses.
Identifying and Accounting for The Incremental Costs of Obtaining a Contract
Accounting Standards Codification (ASC) 340 outlines the requirements for an incremental cost. Specifically, ASC 340-40-25-1 through 25-4 states,
25-1: An entity shall recognize as an asset the incremental costs of obtaining a contract with a customer if the entity expects to recover those costs.
25-2: The incremental costs of obtaining a contract are those costs that an entity incurs to obtain a contract with a customer that it would not have incurred if the contract had not been obtained (for example, a sales commission).
25-3: Costs to obtain a contract that would have been incurred regardless of whether the contract was obtained shall be recognized as an expense when incurred, unless those costs are explicitly chargeable to the customer regardless of whether the contract is obtained.
25-4: As a practical expedient, an entity may recognize the incremental costs of obtaining a contract as an expense when incurred if the amortization period of the asset that the entity otherwise would have recognized is one year or less. (emphasis added)
Under ASC 340-40, entities capitalize costs that meet the following two criteria:
- The cost must be incremental in nature. Only the incremental costs incurred because of obtaining a contract should be capitalized. Examples include sales commissions or legal fees if a lawyer agrees to only receive payment upon successful completion of a negotiation. Costs such as the salesperson’s salary, travel costs incurred in negotiations, marketing, and proposal costs do not meet the criteria because those costs would have been incurred regardless of whether the company ultimately obtained the contract. The exception to this rule is if the costs are explicitly chargeable to the customer, regardless of whether the contract is obtained. In this case the asset would be a receivable rather than an asset amortized as an expense.
- The cost must be recoverable. Management should assess the recoverability of incremental costs on a contract-by-contract basis. Management should consider many factors when assessing recoverability, including historical experience with similar contracts, variable consideration such as discounts or returns, potential renewals, or follow-on contracts.
As a practical expedient, the standard allows companies to elect to expense incremental costs if the amortization period is one year or less. Though not explicitly stated in the standard, some firms believe that if entities choose this approach, it would be considered an accounting policy election and the same approach must be applied to all similar short-term contract acquisition costs (the policy election may only be relevant for similar contracts and not across the entire entity).
The recognized asset should be amortized on a systematic basis consistent with the transfer to the related customer of the goods or services. (ASC 340-40-35-1). The method for determining the pattern of amortization should be consistent with the method used to determine the pattern of revenue recognition or to measure progress (see our Input Vs. Output Methods article).
Judgment is required to determine the period over which capitalized incremental costs will be amortized when there are anticipated renewal contracts. In certain instances, the recognized asset will be amortized over a period of benefit that may be longer than the initial contract. The Financial Accounting Standards Board (FASB), in its Revenue Recognition Implementation Q&As, has suggested that if a renewal commission paid is commensurate with the initial commission paid, then the first commission is amortized over the initial contract term, excluding the renewal period. However, if the first commission is disproportionately greater than, and not commensurate with, the renewal commission, then the first commission is amortized over the total expected benefit period, including the renewal. In Question 72, the FASB clarified that the word “commensurate,” using the Oxford English Dictionary as a foundation, means “corresponding in size or degree, in proportion.” The FASB clarified that when determining if multiple commissions are commensurate, entities should evaluate the commission costs relative to the additional value transferred in the contract, not relative to the effort to secure the contract. Refer to the examples below for additional illustrations of when a renewal commission cost is or is not commensurate with the initial commission, as well as the effect that may have on the amortization periods.
Examples of Accounting for Incremental Costs of Obtaining a Contract
The following are real-company examples of how to account for incremental costs under ASC 606. The first and second examples are analyses of companies applying contract commission, and the third is an example of a company that does not capitalize the incremental costs, in favor of an expense recognized yearly. This satisfies the requirement of the practical expedient.
Capitalizing commission costs often best represents the economic fact that incurring the commission costs provides both current and future benefit. Capitalized commission costs are those costs incurred to obtain a contract that would not have been incurred if the contract had not been obtained. This article has focused on contract commissions but could be reasonably applied to fringe benefits and other bonuses. Careful analysis should be completed for each contract and contract renewal to best determine economic life. Although these evaluations can vary, recognizing costs over the life of the asset often provides the clearest picture of when revenue and corresponding costs should be recognized.
- ASU 2014-09: “Revenue from Contracts with Customers.” BC297-BC303.
- EY, Financial Reporting Developments: “Revenue from contracts with customers.” October 2018. Section 9.3.
- FASB Q&As Question 72: “How should an entity evaluate whether a commission paid for a renewal is “commensurate with” a commission paid on the initial contract?.” January 2020.
- PWC, “Revenue From Contracts With Customers.” August 2020. Chapter 11.
- ASC 340-40-25-1 through 25-4, ASC 340-40-35-1