In obtaining a contract, companies sometimes incur costs that would not have been incurred if the contract was not obtained. Many different costs can meet this definition; however, the most common example of this type of cost is a sales commission.
Under Accounting Standards Codification (ASC) 605, companies have the option to treat these incremental costs as expenses or to capitalize (and subsequently amortize) them. Under the revised portion of ASC 340, that option no longer exists, and these costs are to be recognized as assets and amortized. This may be a significant change for many companies who expensed those costs as incurred under ASC 605. As a part of Accounting Standards Update (ASU) 2014-09, ASC 340-40 Other Assets and Deferred Costs – Contracts with Customers was added to provide guidance on other assets and deferred costs relating to contracts with customers. 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 as a result 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 customer of the goods or services to which the asset relates (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 measuring progress (input/output method).
It may require judgment to determine the period over which to amortize these incremental cost assets 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 Transition Resource Group (TRG) 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 TRG memo 23, the staff clarified that the word “commensurate,” using the Oxford English Dictionary as a foundation, means “corresponding in size or degree, in proportion.” TRG 57 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 regarding when a renewal commission cost is or is not commensurate with the initial commission and its effect on the amortization periods.
Technology Company A incurred the following costs in order to obtain a three year contract with Customer B. Company A expects to recover all the costs incurred in order 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 sales person. 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
Consider the same facts as 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 transfer of goods or services under the original contract and the renewal period. However, if Company A pays another commission for the contract renewal, the amortization for the original contract would be just the three years of the first contract.
Example B2: Contract with a lower commissioned renewal option.
Consider the same facts as 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% 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%) and $3,500 (3.5%) 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.
Consider the same facts as 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% 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.
Consider the same facts as 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 of the costs as incurred instead of recognizing an asset and subsequently amortizing it.
Diversity in Thought
In the Basis for Conclusions (BC) for the new standard published by the Financial Accounting Standards Board (FASB), the board noted that some companies may find it difficult to determine whether a commission payment is incremental to a contract. For example, credit card transaction fees, commissions that are dependent upon successfully acquiring multiple contracts, bonuses based on sales targets, or bonuses based on sales and qualitative factors. Because of this, the FASB considered allowing companies the option to expense these costs as incurred, but ultimately opted against it in favor of comparability. Companies are already struggling with many of these issues.
Consider a firm that pays a 2% transaction processing fee to a credit card processing company each time a credit card payment is made.
View A – Arguments for capitalization. The processing fee is an incremental cost because it fluctuates with and is only incurred when contracts are obtained and sales are made. Supporters of this view could argue that if the credit card service was not available, the contract likely would not have been obtained and therefore would be an incremental cost of obtaining the contract.
View B – Arguments against capitalization. Those arguing against capitalization of these costs would claim that while the cost is incremental to obtaining the contract, the processing service was a result of obtaining the contract and not an effort to obtain the contract. The firm will need to determine if the cost was incurred while obtaining the contract or executing the terms of the contract. If there are many contracts of a similar nature and the payment processor is used for only some, or if a customer could decide at the last moment to pay using another method, it is unlikely that the cost (while incremental) would be considered a “cost of obtaining the contract.”
Consider a company that pays its salespeople a $5,000 commission for every $100,000 of gross sales. The company expects each $100,000 increment to be made up of 3-5 separate contracts.
View A – Arguments for capitalization. The commissions are incremental to sales because they would not have been incurred if the contracts hadn’t been obtained. The costs are generally easy to accurately attribute to each individual contract (5% of the gross amount of each individual contract). If the company is certain that it will pay the commission and it is clear which portion of that commission relates to a specific contract, it appears reasonable that an entity would capitalize the proportionate amount of the sales commission for each contract. There is another view among those who would capitalize this cost that would argue that the commission would be allocated only to the last contract completing the $100,000. This would be a more literal interpretation of the rule because the entire commission is technically incremental to that last contract.
View B – Argument against capitalization. The commission is dependent on multiple contracts and is not incremental to any one contract. There is uncertainty when a contract is acquired about whether a cost will be incurred. Further, companies may experience significant operational complexities in tracking the timing and allocation of commissions to specific contracts. For example, $70,000 of gross sales may occur in one financial reporting period, while the remaining $30,000 of gross sales to be commissioned is incurred in the following financial reporting period.
Additional fact patterns that result in a similar premise as Issue 2
Bonuses. A company pays its sales force bonuses at the end of the year based purely on sales data. All sales employees receive the same bonus based on reaching group objectives. For this example, companies may want to consider how easy the sales target is to reach. If a sales goal is always met, the cost may be more like a salary than a commission.
Sales-based incentive pay for managers. Many companies offer incentive pay to sales managers that is based on achieving sales targets. An individual salesperson typically receives a commission on each individual sale. A Sales Manager may not get commissions but typically will receive a bonus on target sales for the group of people being managed. Should the amount paid to the Sales Manager be considered an incremental costs?
Commissions only incremental to final contract. One additional view related to the situations outlined under Issue 2 is whether only the last contract to make up the sales target at which the commission is paid out would be considered the “incremental” cost. This view could be reached through a literal interpretation of the guidance. This view does not really reflect the economics of the transaction and may not reflect the original intent of the FASB, nevertheless, it is understandable how this conclusion could be reached from the standard.
There are several different factors that should be taken into account as companies analyze their own situations. Would the cost be incurred if the contract had not been obtained? Can the cost be linked to a specific contract? Is the amount of the cost certain? Was the cost incurred in order to obtain the contract or is it a cost of fulfilling obligations within the contract?
There are many additional questions that companies may need to consider, including the following: If an entity determines that it will capitalize commissions based on acquiring multiple contracts, should the company estimate the amount that should be capitalized at the time each contract is acquired? Should the timing of the cost and the acquisition of the contract be a factor? Would an entity more easily justify capitalizing bonuses based on daily or weekly goals than monthly or yearly goals?
Comparison to 605
The change in treatment of incremental costs of obtaining a contract may be a big change for many companies. Under ASC 605, companies made a policy election to either expense these costs as incurred or to capitalize them.
Companies that currently expense incremental costs of obtaining a contract will have to track those costs for the multiple years prior to ASC 606 adoption regardless of the implementation approach selected. Because companies have the option under ASC 605 to either expense or capitalize incremental contract costs, companies may want to make an accounting policy change as early as possible in order to ease the transition. Companies that make an accounting policy change must do so on the basis of preferability.
EY points out another implementation issue on page 29 of their ASC 606 guide, “Technical Line: A closer look at the new revenue recognition standard”: companies currently capitalizing costs to obtain a contract by analogizing to the guidance in ASC 310-20 on salaries and benefits for salespeople will need to reevaluate their policies because those costs may not be incremental and would not be eligible for capitalization under the new standard.
The capitalization of costs incremental to obtaining a contract is one of the areas that may be significantly affected by the new standard. Companies no longer have the option to immediately expense these costs unless the amortization period would be one year or less. There is still some uncertainty regarding whether commission and bonus structures that are more complex should be capitalized.
- EY, Technical Line: A closer look at the new standard. 16 June 2014.
- ASU 2014-09: “Basis for Conclusions.” BC 297-303.
- EY, Financial reporting developments: “Revenue from contracts with customers.” Revised October 2018. Section 9.3 “Contract Costs.”
- PWC, Revenue from contracts with customers. September 2018. Chapter 11 “Contract Costs.”
- FASB, ASU 2014-09 Section C: Background information and basis for conclusions. BC297-BC303.
- FASB TRG Memo 23: “Incremental Costs of Obtaining a Contract.” 26 January, 2016.