Incremental Costs of Obtaining Customer Contracts and Implementing Commission Plans

Introduction

With the issuance of ASC 606, Revenue from Contracts with Customers, a new subtopic was added known as subtopic ASC 340-40 to codify the guidance on other assets and deferred costs relating to contracts with customers. This guidance specifies the accounting for costs an entity incurs to acquire and fulfill a contract to provide goods and services to customers if costs to acquire or fulfill a contract are not within the scope of another. This white paper will discuss the proper accounting treatment of costs associated with executing a customer contract. The Solaris advisory practice is here to assist clients with managing the proper accounting treatment under ASC606 and Subtopic 340-40.  Solaris will also assist clients with designing company-wide policies for contract costs to facilitate a formalized process and policy.

Key Provisions Under ASC 606 and ASC 340-40

Acquisition Costs:

Under ASC 340-40,25-1, the incremental costs of obtaining a contract with a customer are recognized as an asset if the entity expects to recover those costs.  Incremental costs are those that an entity would not have incurred if the contract had not been obtained (for example, sales commission).  Costs that would have been incurred regardless of whether the contract was obtained shall be expensed when incurred, unless those costs are explicitly chargeable to the customer regardless of whether the contract is obtained.  An entity can expect to recover contract acquisition costs through direct recovery (i.e., reimbursement under the contract) or indirect recovery (i.e., through the margin inherent in the contract).  

In accordance with ASC 340-40-25-4, 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.  If an entity elects to apply the practical expedient, then it applies the practical expedient across all of its business units or segments and to all contracts that qualify for the expedient (regardless of whether the contract qualifies as a new contract with a customer or a renewal contract)¹.

Fulfillment Costs

ASC 340-40 divides contract fulfillment costs into two categories: (1) those that give rise to an asset and (2) those that are expensed as incurred. In accordance with ASC 340-40-25-5, an entity shall recognize an asset from the costs incurred to fulfill a contract only if those costs meet all of the following criteria:

1. The costs relate directly to a contract or to an anticipated contract that the entity can specifically identify (for example, costs relating to services to be provided under renewal of an existing contract or costs of designing an asset to be transferred under a specific contract that has not yet been approved).

2. The costs generate or enhance resources of the entity that will be used in satisfying (or in continuing to satisfy) performance obligations in the future.

3. The costs are expected to be recovered.

ASC 340-40-25-7 states that costs that relate directly to a contract (or a specific anticipated contract) include any of the following:  

1. Direct labor (for example, salaries and wages of employees who provide the promised services directly to the customer)

2. Direct materials (for example, supplies used in providing the promised services to a customer)  

3. Allocations of costs that relate directly to the contract or to contract activities (for example, costs of contract management and supervision, insurance, and depreciation of tools and equipment used in fulfilling the contract)  

4. Costs that are explicitly chargeable to the customer under the contract  

5. Other costs that are incurred only because an entity entered into the contract (for example, payments to subcontractors).

Per guidance at ASC 340-40-25-8, an entity shall recognize the following costs as expenses when incurred:  

1. General and administrative costs (unless those costs are explicitly chargeable to the customer under the contract, in which case an entity shall evaluate those costs in accordance with paragraph 340-40-25-7)  

2. Costs of wasted materials, labor, or other resources to fulfill the contract that were not reflected in the price of the contract  

3. Costs that relate to satisfied performance obligations (or partially satisfied performance obligations) in the contract (that is, costs that relate to past performance)  

4. Costs for which an entity cannot distinguish whether the costs relate to unsatisfied performance obligations or to satisfied performance obligations (or partially satisfied performance obligations).

If the fulfillment costs falls within another applicable GAAP literature then ASC 340-40 does not apply.

Amortization of Contract Cost Assets:

Per the guidance within ASC 340-40-35-1, an asset recognized in accordance with the acquisition cost (ASC 340-40-25-1) or fulfillment cost (ASC 340-40-25-5) guidance shall be amortized on a systematic basis that is consistent with the transfer to the customer of the goods or services to which the asset relates. The goods and service to which amortization of a contract cost asset relates can include the existing goods and services in a contract as well as those to be transferred under a specifically anticipated contract as described within paragraph 340-40-25-5(a).  

In determining the amortization period of a contract cost asset, TRG members agreed that the evaluation of whether a renewal commission is commensurate with an initial commission should be assessed as this could be indicative of a useful life that is longer than the stated contract term as the period over which the asset is expected to contribute to an entity’s future cash flows may include an anticipated renewal period.  

As the guidance requires a contract cost asset to be amortized on a systematic basis that is consistent with the transfer to the customer of the goods or services to which the asset relates, TRG members considered the amortization method of a contract cost asset that relates to a contract with goods and services that transfer at different points in time. TRG members generally agreed that it is reasonable to amortize a contract cost asset using a single measure of progress considering all of the distinct goods or services to which the asset relates.

Impairment of Contract Cost Assets:

In accordance with ASC 340-40-35-3 an entity shall recognize an impairment loss in profit or loss to the extent that the carrying amount of an asset recognized in accordance with the acquisition cost (ASC 340-40-25-1) or fulfillment cost (ASC 340-40-25-5) guidance exceeds:

1. The amount of consideration that the entity expects to receive in the future and that the entity has received but has not recognized as revenue, in exchange for the goods or services to which the asset relates (“the consideration”)

2. The costs that relate directly to providing those goods or services and that have not been recognized as expenses (see paragraph 340-40-25-2 and 340-40-25-7).

As described in ASC 340-40-53-4, in applying the above guidance to determine the consideration, an entity shall use the principles for determining the transaction price (except for the guidance in paragraphs 606-10-32-11 through 32-13 on constraining estimates of variable consideration) and adjust that amount to reflect the effects of the customer’s credit risk. When determining the consideration for the purposes of paragraph 340-40-35-3, an entity also shall consider expected contract renewals and extensions (with the same customer).  

Additional Considerations:

TRG members discussed the underlying principle for capitalizing costs under the standard and generally agreed that neither ASC 340-40 nor ASC 606 amended US GAAP liability guidance. Therefore, entities should first refer to the applicable liability standard to determine when they are required to accrue for certain costs. Entities would then use the guidance in ASC 340-40 to determine whether the related costs need to be capitalized.

Furthermore, ASC 606 includes a practical expedient that allows an entity to apply ASC 606 to a portfolio of contracts with similar characteristics if the entity reasonably expects that the financial statement effects of applying ASC 606 to the portfolio would not differ materially from applying it to the individual contracts.  The FASB did not intend for entities to have to quantitatively evaluate the accounting outcomes from applying a portfolio approach v. not applying a portfolio approach. Even though Topic 340-40 does not provide this practical expedient, it is believed that the practical expedient still would apply for contract costs within Subtopic 340-40.  As such, the entity will assess if it is appropriate to elect the practical expedient and if so will develop estimates using a portfolio of data for a specific contract with a customer.  Such estimates could include estimates about the expected customer life or collectability².

The Subtopic 340-40 accounting guidance mentioned above can be summarized in a diagram shown below:  

Conclusion

When entering into a sales contract with a customer or implementing a commission plan, a company first needs to consider when it would be required to recognize the liability for contract costs (both acquisition and fulfillment) or commission expense.  These costs should also be accessed for applying the practical expedient where an entity is permitted to immediately expense contract acquisition costs when the amortization period of such costs would be one year or less. When applying the practical expedient the entity must assess the period from the date the commission is earned through the date control of the underlying goods/services is transferred. The Company has elected to apply this practical expedient when it is applicable.  Contact a Solaris consultant to for assistance with properly treating costs with obtaining a contract with a customer and costs related to implementing commission plans.  Solaris is also available to assist with drafting formal company policies related to contract costs. Contact us at info@solarisadv.com.