Accounting Standards Codification (ASC) 606 not only updates guidance on revenue recognition, it also adds new guidelines on cost capitalization through ASC 340-40, Contract with Customers. ASC 340-40 provides guidance on incremental costs and contract fulfillment costs. Incremental costs are costs that would not have been incurred if the contract was not obtained (e.g., sales commission). Contract fulfillment costs are costs required for completing a contract. This article focuses on contract fulfillment costs. For more information on incremental costs, refer to Incremental Costs of Obtaining a Contract.
Companies incur many different costs to fulfill contracts. Some of these costs, such as inventory, intangibles, and buildings and equipment, are capitalized under specific guidance. Certain fulfillment costs have not had specific guidance on capitalization previously; however, some of these may be capitalized under ASC 340-40. As a result, some costs that are expensed immediately may be deferred when applying ASC 340-40.
ASC 340-40 requires the company to determine if the incurred cost falls within the scope of other guidance; for example, inventories, fixed assets, and software development. A cost that is not within the scope of other guidance would be capitalized if it meets 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). These costs may be direct labor and material cost, cost allocated directly to the contract, cost explicitly charged to the customer, and cost of obtaining the contract.
- The cost generates or enhances resources that will be used to fulfill performance obligations. 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, thus would not be capitalized.
- The vendor expects to recover the cost. The cost is recoverable if they are explicitly reimbursable under the contract or if the transaction price includes the cost.
If a cost directly relates to a contract but does not meet the other two criteria to be capitalized, then that cost is expensed as incurred. Such cost may be the following (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 part of the contract transaction price.
- Costs that relate to past performance in the contracts (i.e., costs related to a satisfied or partially satisfied contract).
When the vendor cannot determine whether a cost relates to a past or a standing performance obligation, and other guidance does not allow the company to capitalize that cost, the entire amount is expensed as incurred. Vendors 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.
A vendor should amortize a capitalized contract fulfillment cost consistent with the pattern of transferring goods or services to which the cost relates. The goods and services can come from an existing contract and a specific anticipated contract. For example, a data storage company has a contract to provide service to a customer for three years. The company also expects to renew the contract for another three years at the end of the three-year contract. Contract fulfillment costs related to the data storage service would be amortized over the six-year period.
When 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 vendor 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.
Impairment tests should be performed at the end of each reporting period. To test for impairment, a vendor should focus on whether the capitalized contract fulfillment cost is recoverable. The test is completed by comparing the asset’s carrying value to the remainder of the expected contract transaction price, less the direct costs of providing the good or service (e.g., direct labor and direct material) that have not been recognized as expenses. If the carrying value is greater than the expected transaction price, then the capitalized cost is impaired.
The vendor should use the transaction price determined in Step 3 of the Revenue Recognition Model for the impairment test. If the transaction price is reduced due to the constraint on variable consideration, then the unconstrained amount should be used. To use the unconstrained transaction price for the impairment test, that price must be reduced to reflect the customer’s credit risk.
Before using ASC 340-40 to recognize impairment loss, the vendor should consider other applicable guidance such as ASC 350, Property, Plant, and Equipment, and ASC 360, Intangibles—Goodwill and Other. Once losses are recognized, the vendor should not reverse previously recognized impairment losses even when reasons for the impairment no longer exist.
Types of contract fulfillment costs
In general, contract fulfillment costs may be categorized into three types:
Set-up Cost. Set-up cost is any direct cost incurred at contract inception to enable the vendor to fulfill its performance obligation. For example, a construction company may need to mobilize its equipment to a construction site in order to commence the building process. The cost to move the equipment is considered a set-up cost. The vendor should consider whether the cost is (1) related directly to an existing/specific future contract, (2) used to enhance/generate resources to fulfill the contract, and (3) expected to be recovered. If the set-up cost meets all three criteria, then that cost would be capitalized.
Learning Curve Cost. Learning curve costs occur as the cost of providing a good or service declines when the vendor becomes more efficient at providing the good or service. For example, a manufacturer produces a type of semiconductor at a lower cost over time. Learning curve costs typically include overhead, labor, and reworking costs. Such costs are first capitalized and then recognized in cost of sales if they are incurred for a single performance obligation that is satisfied over time. The vendor may use a method, such as cost-to-cost, that recognizes more revenue and expenses for units delivered earlier in the contract. For more information on ratable recognition, refer to Revenue Recognition over Time. For learning curve costs that relate to a single performance obligation but for which the obligation is satisfied at a point in time, the vendor should consider other existing guidance (e.g., inventory).
Abnormal Cost. Abnormal costs are costs that are not anticipated in fulfilling a contract. Abnormal cost may result from spoiled materials or excessive labor costs. These costs arise from factors such as changes to contract scope and unexpected delays. Abnormal costs are generally expensed as incurred.
Vendor 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 vendor designs a new platform to store the customer’s data, which includes a server and software for internal use. The vendor also incurs cost to implement the platform. Additionally, Vendor 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 Vendor 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. Vendor 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.
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).
Comparison to Other Standards
Before adopting ASC 340-40, companies often establish policies to expense contract fulfillment costs as incurred due to the lack of specific U.S. Generally Accepted Accounting Principles (GAAP) guidance. Before ASC 340-40, companies could choose to capitalize or expense certain set-up costs under guidance from the Securities and Exchange Comission (SEC), specifically, incremental and direct costs that are not covered by other guidance but are related to transactions that result in deferring revenue. Under ASC 340-40, however, set-up costs would be capitalized if they meet the three criteria. Therefore, a company may experience a higher net income for the year that contract fulfillment costs are incurred and capitalized rather than being expensed immediately.
According to the SEC guidance (“Speech by SEC Staff: 2003 Thirty-First AICPA National Conference on Current SEC Developments”), a company does not need to recognize a loss on a delivered good in a multiple-element arrangement if the loss occurs only because (1) it is the result of applying contingent revenue provision, and (2) it is expected to be recovered as all of the goods in the arrangement are delivered. In contrast, ASC 340-40 does not provide the same provision as the SEC guidance, thus expenses would be recognized before revenue in certain situations. For instance, if the variable consideration constraint applies to all or a portion of the expected revenue in a contract and the constraint would result in an upfront loss on a satisfied performance obligation, then the company would recognize that loss (i.e., recognizing expenses before recognizing the expected revenue). For more information on variable consideration constraint, refer to Variable Consideration and the Constraint.
Under current standard, companies are required to defer nonrefundable upfront fees if they are in exchange for goods and services already promised in a contract (i.e., not for other goods and services). If the amount of deferred nonrefundable upfront fees exceeds deferred costs, then both amounts must be recognized over the same period and in the same manner. If the amount of deferred costs is greater than deferred nonrefundable upfront fees, then the net of deferred cost and deferred revenue is recognized over the shorter of the stated contract period and the estimated customer life. ASC 340-40 removes this requirement—the amortization schedule for deferred costs does not have to match the revenue recognition pattern of nonrefundable upfront fees. As a result, when a deferred contract fulfillment cost is greater than a deferred nonrefundable upfront fee, the deferred cost may be amortized over a longer period than it would be under current guidance.
ASC 340-40 allows companies to capitalize some contract fulfillment costs. When implementing ASC 340-40, companies should first assess whether the cost in question is covered by other guidance. To be capitalized under ASC 340-40, a cost must 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.
Since a company would defer some contract fulfillment costs under ASC 340-40, a company’s income statement may reflect a higher net income in the year that contract fulfillment costs are capitalized. In some cases, if some or all of the revenue is constrained in a contract, then the company would recognize an upfront loss even when the related performance obligation is satisfied. Amortization of contract costs is no longer associated with revenue recognition of nonrefundable upfront fees. As a result, capitalized contract costs may be amortized over a longer time period than they would be previously.
- ASC 340-40-25-5, 25-8.
- ASU 2014-09: “Basis for Conclusions.” BC 304-316.
- EY, Financial reporting developments: “Revenue from contracts with customers.” Revised August 2017. Section 8.3.2 “Cost to fulfill a contract” and Section 8.3.3 “Amortization and impairment of capitalized costs.”
- KPMG, Issues In-Depth: “Revenues from Contracts with Customers.” May 2016. Sections 6.2 “Costs of fulfilling a contract,” Section 6.3 “Amortization,” and Section 6.4. “Impairment.”
- PWC, “Revenue from contracts with customers.” August 2016. Sections 11.3 “Costs to fulfill a contract” and Section 11.4. “Amortization and impairment.”
- SEC, Speech by SEC Staff: “2003 Thirty-First AICPA National Conference on Current SEC Developments.” Delivered by Russell P. Hodge. 11 December 2003.
- SEC, Staff Accounting Bulletin No. 104. 17 December 2003.