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
Example A: Costs Related to Delivery of a Bid
Technology Company A incurred the following costs to obtain a three-year contract with Customer B. Company A expects to recover all the costs incurred to obtain the contract.
|Travel Costs to Deliver Bid Proposal||$8,000|
|Commissions Paid to Salesperson||$5,000|
Company A should only capitalize the $5,000 commission paid to its salesperson. The costs related to the delivery of the bid on the contract do not qualify because those costs would have been incurred even if the company did not ultimately obtain the contract. Company A should amortize the recognized asset over the three-year contract term.
Example B1: Contract with a Non-Commissioned Renewal Option
Assume the same facts as in Example A, except that the contract contains a renewal option for an additional three years. Company A does not pay any additional commission for the contract renewal. Based on historical experience with similar customers, Company A expects Customer B to renew the contract for one additional three-year period.
In this case, the amortization period would be six years because the recognized asset relates to the transfer of goods or services under the original contract and the renewal period.
Example B2: Contract with a Lower Commissioned Renewal Option
Assume the same facts as in Example A, except that the contract contains a renewal option for an additional three years. Company A pays an additional commission of $3,500 (or 3.5 percent of total contract value) upon renewal. Based on historical experience with similar customers, Company A expects Customer B to renew the contract for one additional three-year period.
Because Company A pays another commission for the contract renewal, Company A must determine if the commissions are commensurate. Assuming the value of the three-year renewal contract is equal to the value of the initial three-year contract, the different commissions of $5,000 (5 percent) and $3,500 (3.5 percent) are not commensurate. The first commission of $5,000 is amortized over six years, and the $3,500 commission is amortized over the last three years under the renewal contract period.
Example B3: Contract with a Commensurate Renewal Option
Assume the same facts as in Example A, except that the contract contains a renewal option for an additional three years. Company A pays an additional commission of $5,000 (or 5 percent of total contract value) upon renewal. Based on historical experience with similar customers, Company A expects Customer B to renew the contract for one additional three-year period.
Company A must determine if the two commissions are commensurate. Because the commissions are the same amount and relate to contracts of equal value, they are commensurate. The amortization for the $5,000 commission relating to the original contract would be just three years. The renewal commission of $5,000 would be amortized over the three-year renewal term.
Example C: One-Year Contract Period
Assume the same facts as in example A, except that the contract period is one year. There are also no contract renewal options.
In this scenario, the Company has the option to take advantage of the practical expedient set forth in the standard. The company may expense all the costs as incurred instead of recognizing an asset and subsequently amortizing it.
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.
Paychex Inc. is a human resource outsourcing company. Paychex provides payroll, benefits, and human resource services for other companies. The company responded to an inquiry from the SEC in March 2020 regarding incremental sales commissions on its contracts. The analysis Paychex provided is as follows, which is taken directly from the company’s comment letter to the SEC:
-Sales commissions are paid on each new contract sold. Sales commissions are considered incremental costs as they would not be incurred unless the underlying sales were completed.
-Sales bonuses are typically earned once a certain level, or tier, of sales units (or revenue) has been achieved. Achievement is based on cumulative sales during a period, which consists of multiple contracts. Sales bonuses incurred based on new contracts sold are considered incremental costs.
-The Company incurs FICA expenses and 401(k) match expenses on compensation paid in the form of sales commissions and sales bonuses. The Company considers these fringe benefit costs to be incremental as they would not be incurred if the underlying sales were not completed. (March 2020)
In the letter to the SEC, Paychex reported that all commissions, bonuses, and related expenses are evaluated alongside the economic benefit and life of the contract. The company also concluded that “each of the above incremental costs act as an incentive to obtain a contract and would not be incurred unless the underlying sales were completed.” The company then agreed to expand/revise future 10-K disclosures to explain to investors more clearly how it accounts for incremental costs of obtaining a contract.
Gartner Inc. is a global information technology (IT) research and consulting company. In the company’s correspondence with the SEC, it needed to describe more about the company’s incremental costs of commissions in relation to the purchased contracts. When responding to the SEC’s questions, Gartner provided an explanation for its accounting treatment of commissions related to multi-year contracts:
Under the Company’s commission plans for multi-year Research subscription contracts, salespeople are allocated commission credits one year at a time. The Company pays those commissions on a comparable basis (i.e., when commission credits are allocated each year). Commission credits are an integral part of the Company’s formula to determine commissions payable on an employee by employee basis. The Company’s practice aligns the timing for recognizing a liability with its incurrence of an obligation to its salespeople.
For subscription contracts that follow-on an initial multi-year Research subscription contract that is expiring, Gartner compensates its salespeople on a similar basis as the initial subscription contract. Therefore, commissions on a renewal contract are commensurate with each of the years from the initial multi-year contract.
In summary, the Company concluded that each commission tranche for a multi-year Research subscription customer contract, including subsequent renewals, should be capitalized at the beginning of the related service period and amortized prospectively on a ratable basis over a period that does not exceed one year. By consistently applying this methodology, deferred commissions are amortized over a period that is consistent with the transfer to the customer of the services to which the asset relates and the resulting amortization expense directly aligns with the Company’s pattern of revenue recognition. (January 2020)
Gartner concluded that a reevaluation for each period renewal provides the most accurate information for capitalizing and amortizing the commissions as part of the contract.
CorVel Corporation is a services management group focusing on healthcare, compensation, and liability management. The company started business in California in 1987. In 2019 CorVel’s revenue reached almost $600 million. In its response letter to the SEC, CorVel disclosed the reasoning behind its accounting treatment of commissions.
The Company has an internal sales force compensation program where remuneration is based solely on the revenues recognized in the period and does not represent an incremental cost to the Company which provides a future benefit expected to be longer than one year and would meet the criteria to be capitalized and presented as a contract asset on the Company’s consolidated balance sheets. (April 2020)
In other words, sales commission or compensation does not meet the classification of incremental costs regarding the contract and is recognized yearly as an expense. This means that it satisfies the requirement of the practical expedient, recognizing revenue as costs are incurred.
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?.” 20 January 2020.
- PWC, “Revenue from contracts with customers.” September 2018. Chapter 11.