When the FASB created ASC 606, they also added a new subtopic on cost capitalization in contracts with customers, which can be found in ASC 340-40. This subtopic provides guidance on incremental costs and contract fulfillment costs. Incremental costs are costs that would not have been incurred if the contract had not been obtained (e.g., sales commission). Contract fulfillment costs are costs required for completing a contract (e.g., direct labor, costs explicitly chargeable to a customer). This article focuses only on contract fulfillment costs. For more information on incremental costs, refer to Incremental Costs of Obtaining a Contract.
Companies incur many different costs when fulfilling contracts with customers. This includes the purchase or development of inventory, software, intangible assets, and other property and equipment. Many such purchases had well established capitalization guidance before ASC 340-40 was created. ASC 340-40 provides for the first time a set of general guidelines for capitalizing fulfillment costs such as direct labor, direct material, and costs explicitly chargeable to a customer. It also provides guidance on amortizing these capitalized fulfillment costs.
Considerations in Accounting for Costs to Fulfill a Contract
ASC 340-40 requires a company to determine if an incurred contract fulfillment cost falls within the scope of other guidance—for example, inventories, fixed assets, and software development. When such guidance already exists, companies must follow that guidance. Costs that are not within the scope of other guidance should be capitalized if they meet all of the following criteria (ASC 340-40-25-5):
- The cost relates directly to an existing contract or a specific anticipated contract (such as an anticipated contract renewal).
- The cost generates or enhances resources of the company that will be used to satisfy performance obligations in the future. For example, engineering and design costs incurred to build a server to store customer data would be capitalized. In contrast, systematically assigned overhead costs do not generate or enhance resources for fulfilling performance obligations, and thus would not be capitalized.
- The company expects to recover the cost. The cost is recoverable if it is explicitly reimbursable under the contract or if the transaction price includes the cost.
The following costs should be expensed when incurred (ASC 340-40-25-8):
- General and administrative costs not explicitly chargeable to the customer.
- Costs of wasted resources such as labor and material to fulfill a contract that are not reflected in the contract price.
- Costs that relate to past performance in the contracts (i.e., costs related to a satisfied or partially satisfied contract).
- Costs for which an entity cannot determine whether the costs relate to unsatisfied, satisfied, or partially satisfied performance obligations
Companies should not defer an expense solely to match that expense with the related revenue. This is the case even when the related revenue contains variable consideration that has been constrained.
Amortization of Contract Costs
A company should amortize a capitalized contract fulfillment cost consistent with the pattern of transferring the goods or services to which the cost relates. The goods and services may relate to a specific anticipated contract in addition to the existing contract. For example, a data storage company that has a three-year contract with a customer and expects the customer to renew that contract for another three years would amortize any capitalized fulfillment costs (e.g., data storage design costs) over the six-year period.
If the expected timing of transferring goods or services changes significantly (e.g., the goods are transferred in two years instead of the original estimate of five years), the company should revise the amortization amount to reflect the change on a current prospective basis in accordance with ASC 250, Accounting Changes and Error Corrections.
Companies should note that under ASC 340-40 and ASC 606, the amortization pattern for contract fulfillment costs does not have to match the revenue recognition pattern for nonrefundable upfront fees. This is true even when contract fulfillment costs and nonrefundable upfront fees are deferred in the same contract.
Example A: Different Guidance For Different Costs
Company A signs a contract to store a customer’s data for six years and it expects the customer to renew the contract for two more years when the original contract expires. In order to fulfill the contract, the company designs a new platform to store the customer’s data, which includes a server and software for internal use. The company also incurs cost to implement the platform. Additionally, Company A systematically allocates some of its general and administrative cost to the contract. Although the customer does not receive control of the platform, the cost of the platform is reflected in the contract transaction price. The following are the costs that Company A incurs to set up the storage center:
Hardware Cost……………….. $50,000
Design Cost…………..………. $40,000
Allocated G&A Costs…………. $20,000
In this example, the hardware cost is accounted for in accordance with ASC 360 while the software cost is accounted for under ASC 350-40, Internal-Use Software. According to ASC 340-40, the design and implementation costs are capitalized because (1) they relate directly to the six-year contract and the anticipated two-year contract; (2) they generate a resource (the platform) that will be used to fulfill the contract and the anticipated contract; (3) they are expected to be recovered as they are reflected in the six-year contract transaction price. Company A should amortize the design and implementation costs over eight years (the original contract and the specific anticipated contract). On the other hand, the G&A cost allocated to the contract should be expensed as incurred because it does not generate or enhance a resource.
Example B: Reworking Cost
Manufacturer B obtains a contract to produce highly customized car frames to a customer for eight years. Due to the highly customized nature of the product, Manufacturer B could not sell the car frames to another customer without incurring significant cost. Should the customer terminate the contract early, the manufacturer can receive payment for all of the work completed up to the termination date. Manufacturer B expects to incur a significant amount of reworking cost during the earlier years of the contract, and less as time goes on. How should Manufacturer B account for the reworking cost (assuming that the contract’s performance obligation is satisfied over time)?
The contract in this example has one performance obligation—to provide highly customized car frames to the customer—and this contract is satisfied over time. Therefore, the reworking cost should be capitalized. The amortization recognized in a particular year during the contract will depend on the method that the manufacturer chooses to recognize revenue over time (most likely the cost-to-cost method).
Astronics Corporation Correspondence With The SEC On Capitalization of Costs
Astronics Corporation is an aerospace electronics corporation known for their innovative technology solutions which include lighting and electronics integrations and semiconductor test systems. In October 2018, Astronics responded to an inquiry from the SEC regarding its capitalization of costs. Astronics explained:
Following the adoption of ASC 606, the Company considered the guidance set forth in ASC 340-40, and determined that these costs represent costs to fulfill a contract under ASC 340-40-25-5… The pre-contract costs capitalized and disclosed in Note 1 represent the capitalization of certain costs to fulfill a contract. The capitalized pre-contract costs (fulfillment costs) relate to goods that will be transferred under multiple contracts (the purchase orders) and will be amortized over a period that is consistent with the transfer to the customer of the goods to which the asset relates. (October 2018)
Paychex, Inc. (Form 10-K, 2020): Paychex Recognition of Assets
Paychex, Inc. provides integrated human capital management solutions for small- and medium-sized businesses, including payroll, benefits, human resources, and insurance services. Paychex’s 2020 10-K explains how the company accounts for costs to fulfill contracts:
The Company also recognizes an asset for the costs to fulfill a contract with a client if the costs are specifically identifiable, generate or enhance resources used to satisfy future performance obligations, and are expected to be recovered. The Company determined that substantially all costs related to implementation activities are administrative in nature and meet the capitalization criteria under ASC 340-40. These capitalized costs to fulfill a contract principally relate to upfront direct costs that are expected to be recovered and enhance the Company’s ability to satisfy future performance obligations.
The assets related to both costs to obtain and costs to fulfill contracts with clients are capitalized and amortized using an accelerated method over an eight-year life to closely align with the pattern of client attrition over the estimated life of the client relationship. The Company regularly reviews its deferred costs for potential impairment and did not recognize an impairment loss during the fiscal years ended May 31, 2020 or May 31, 2019. (2020 Form 10-K)
Waitr Holdings Inc. (Form 10-K, 2020): Waitr Holdings’ Treatment of Costs to Fulfill a Contract with a Customer
Louisiana based Waitr Holdings Inc. provides a restaurant platform for online food ordering and delivery services throughout the United States. Waitr connects local restaurants to customers in underserved U.S. markets. The company’s 2020 10-K provides an example of capitalizing and amortizing set-up costs (see Note 2):
The Company also recognizes an asset for the costs to fulfill a contract with a restaurant when they are specifically identifiable, generate or enhance resources used to satisfy future performance obligations, and are expected to be recovered. The Company has determined that certain costs related to menu and other setup and integration activities meet the capitalization criteria under ASC Topic 340-40, Other Assets and Deferred Costs. Costs related to these implementation activities are deferred and then amortized to operations and support expense on a straight-line basis over a period of benefit.
As a result of the changes in the terms of the contracts related to the modified fee structure introduced in July 2019, the Company changed its estimate of the useful life of the asset for costs to fulfill a contract to better reflect the estimated period in which the asset will remain in service. Effective August 1, 2019, the estimated useful life of the asset for costs to fulfill a contract from customers, previously estimated at two years, was increased to five years (2020 Form 10-K)
Impairment of Contract Costs
Impairment tests should be performed at the end of each reporting period and in the occurrence of an event that may indicate the asset’s carrying amount is no longer recoverable. To test for impairment, a company should focus on whether the capitalized contract fulfillment cost is recoverable. If the capitalized costs exceed (1) the amount of consideration the company expects to receive in the future, and (2) any consideration already received but not yet recognized as revenue, less (3) the direct costs of providing the goods or services (e.g., direct labor and direct material) that have not been recognized as expenses, then the difference should be recognized in in profit or loss.
The company should use the principles for determining transaction price in Step 3 of the Revenue Recognition Model when calculating expected consideration for the impairment test. However, if the transaction price would normally have been reduced due to the constraint on variable consideration, the unconstrained amount should be used for impairment testing purposes. In addition, that price must be reduced to reflect the customer’s credit risk for impairment testing purposes.
Before recognizing an impairment loss under ASC 340-40, the company should consider whether impairment losses should be recognized in accordance with other applicable guidance such as ASC 360, Property, Plant, and Equipment, and ASC 350, Intangibles—Goodwill and Other. Once impairment losses are recognized, the company may not reverse such losses, even when reasons for the impairment no longer exist.
ASC 340-40 provides guidance for capitalizing some contract fulfillment costs. Companies should first assess whether the cost in question is covered by other guidance. When not covered by other guidance, contract fulfillment costs should be capitalized under ASC 340-40 if they meet three criteria: (1) the cost is directly related to a current or a specific anticipated contract; (2) the cost generates or enhances a resource that is used to fulfill performance obligations; and (3) the cost is recoverable.
- ASC 340-40-25-5 to 25-8, ASC 340-40-35-1 to 35-6
- ASU 2014-09: “Revenue from Contracts with Customers.” BC304-BC316.
- EY, Financial Reporting Developments: “Revenue from contracts with customers.” September 2021. Section 9.3.2, Section 9.3.3, Section 9.3.4.
- KPMG, Handbook: “Revenue Recognition.” December 2019. Section 12.5, Section 12.6, Section 12.7, Section 12.8, Section 12.9.
- PWC, “Revenue from contracts with customers.” August 2020. Section 11.3, Section 11.4