ASC 606 is usually discussed as a revenue standard, but it came with a companion: ASC 340-40, which governs the costs a company incurs to win and perform customer contracts. Two questions come up on almost every audit of a company that pays commissions or does significant setup work. Which costs should be capitalized instead of expensed, and what has to be disclosed?
This guide covers the cost side of ASC 340-40, the audit procedures for capitalization, amortization and impairment, and the disclosure relief available to entities that are not public business entities. For the revenue side, see ASC 606 revenue recognition and revenue recognition audit procedures.
Costs to obtain a contract
ASC 340-40-25-1 requires an entity to recognize as an asset the incremental costs of obtaining a contract with a customer if it expects to recover them. Incremental means costs the entity would not have incurred if the contract had not been obtained. The classic example is a sales commission.
What qualifies and what does not follows from that definition:
- Qualifies: commissions paid because a contract was signed, and payroll taxes and fringe benefits on those commissions that would not exist without the contract.
- Does not qualify: fixed salaries, even if partly set by reference to projected sales; bid and proposal costs; legal, travel and marketing costs that would have been incurred whether or not the deal closed; and discretionary bonuses tied to several factors such as company profit, because the payment does not change with a specific contract.
A practical test that follows from the definition: would the cost still have been incurred if the customer had backed out just before signing? If yes, it is not incremental.
The one-year practical expedient
An entity may expense incremental costs of obtaining a contract as incurred if the amortization period of the asset it would otherwise recognize is one year or less (ASC 340-40-25-4). The test looks at the expected period of benefit, not the stated contract term. A commission on a one-year contract that the client expects to renew, where no further commission is paid on renewal, relates to more than one year and the expedient is not available. The election should be applied consistently to similar contracts.
Renewal commissions
A renewal commission that is commensurate with the initial commission means the initial commission relates only to the initial term. Commensurate is judged by proportion to contract value, not by the effort required. If the renewal commission is not commensurate, for example 2 percent on a renewal against 10 percent initially, the initial commission relates in part to anticipated renewals and the amortization period can extend beyond the initial term to include anticipated renewals.
Costs to fulfill a contract
Fulfillment costs that are within the scope of another standard, such as inventory or property, plant and equipment, follow that standard. Other costs of fulfilling a contract are capitalized when they meet the criteria in ASC 340-40-25-5 through 25-8, which turn on a direct relationship to a contract and expected recovery. Setup and design costs are the common examples. Some design costs can qualify as costs to fulfill even when bid costs for the same contract are expensed.
Amortization
The capitalized asset is amortized on a systematic basis that is consistent with the transfer of the goods or services to which it relates (ASC 340-40-35-1). The goods or services may include specific anticipated contracts.
- If the related obligations are satisfied over time, amortization should follow the input or output method used to recognize revenue. Straight-line amortization is appropriate only if the transfer is ratable. If a $100,000 commission relates to a contract that is 50 percent complete, the amortized amount is $50,000.
- If a commission relates to several performance obligations, it is allocated among them.
- A significant change in the expected pattern of transfer or the expected period requires updating the amortization period as a change in accounting estimate.
- The expense is presented consistently with the nature of the cost, not with whether it was first capitalized.
Impairment
The asset is impaired to the extent its carrying amount exceeds (a) the remaining consideration the entity expects to receive for the goods or services to which the asset relates, less (b) the costs that relate directly to providing those goods or services that have not been recognized as expenses (ASC 340-40-35-3).
An illustration. A capitalized commission has a carrying amount of $600,000. The entity expects to receive $650,000 more under the contract and expects $150,000 of remaining costs to deliver. The recoverable measure is $650,000 minus $150,000, or $500,000. The impairment loss is $100,000. Impairment losses previously recognized cannot be reversed.
Audit procedures for contract costs
Understand the compensation plans. Obtain commission plans and agreements for sales staff, agents and referral partners. Read them for the triggering event, clawbacks, tiers, and whether payments depend on service after the contract signing.
Reconcile the population. Compare commission expense in the ledger to the capitalized asset and to payroll or accounts payable records. Test that capitalized amounts relate to executed contracts and that amounts for contracts that were not won were expensed.
Test the expedient. If the client expenses commissions under the one-year expedient, test the period of benefit: the contract term, renewal history and whether renewals carry commissions. Contract terms of one year with a track record of multi-year customer relationships are the main exposure.
Recompute amortization. For a sample of contracts, recalculate amortization from the commission, the related performance obligations and the pattern of transfer. Check that the amortization period matches the client's documented policy, and look for contracts that ended early or were cancelled while the asset remained on the balance sheet.
Test impairment. Identify cancelled, disputed and at-risk contracts, and evaluate whether the carrying amount still exceeds remaining consideration less remaining costs. A customer that has terminated is an immediate indicator.
ASC 606 disclosures for entities other than public business entities
A private company does not need to give every ASC 606 disclosure that a public company does. Under the nonpublic-entity elections, the minimum looks like this.
Required:
- Disaggregation of revenue: an entity may skip the quantitative disaggregation but must, at a minimum, show revenue by timing of transfer (point in time versus over time) and describe qualitatively how economic factors affect the nature, amount, timing and uncertainty of revenue and cash flows.
- Contract balances: opening and closing balances of receivables, contract assets and contract liabilities from contracts with customers.
- Performance obligations: descriptive disclosure of when obligations are typically satisfied, significant payment terms and the nature of goods or services.
- Significant judgments: the methods used to recognize revenue over time (input or output) and the methods, inputs and assumptions used to assess the variable consideration constraint.
Optional (an entity may elect to omit):
- the remaining performance obligations disclosure
- the remainder of the contract balance reconciliation, including revenue recognized from opening contract liabilities
- other significant judgment disclosures
- disclosure of the use of practical expedients
- the ASC 340-40 disclosures about assets recognized from the costs to obtain or fulfill a contract, covering closing balances, the amortization method and impairment losses, and the disclosure of use of the incremental-cost expedient
- the interim revenue disclosures
Whatever the client elects to omit, the omission should be a conscious policy, not an accident. Auditors should compare the notes to the elections made, confirm the required disclosures are present and tie the contract balance figures to the general ledger and the balance sheet.
Frequently asked questions
Are sales commissions always capitalized under ASC 606?
No. They are capitalized if they are incremental costs of obtaining a contract and are expected to be recovered, unless the entity elects the one-year expedient and the amortization period is one year or less.
Does a private company have to disclose capitalized contract costs?
The disclosures about contract cost assets are among those a nonpublic entity may elect to omit. The balance sheet amount, the accounting policy and the expense still need to be correct.
Sources
- PwC Viewpoint, Revenue from contracts with customers guide, section 11.2, Incremental costs of obtaining a contract (ASC 340-40-25-1, 25-4): https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/revenue_from_contrac/revenue_from_contrac_US/chapter_11_contract__US/112incremental_costs_US.html
- PwC Viewpoint, section 11.4, Amortization and impairment (ASC 340-40-35-1, 35-3): https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/revenue_from_contrac/revenue_from_contrac_US/chapter_11_contract__US/114amortization_and__US.html
- FASB Transition Resource Group staff paper, Capitalization and Amortization of Incremental Costs of Obtaining a Contract (Nov. 7, 2016): https://viewpoint.pwc.com/dt/us/en/fasb_financial_accou/trg_revenue/trg_revenue_US/capitalization_and_a_US.html
- PwC Viewpoint, Financial statement presentation guide, section 33.5, ASC 606 considerations for private companies (nonpublic-entity disclosure elections): https://viewpoint.pwc.com/dt/us/en/pwc/accounting_guides/financial_statement_/financial_statement___18_US/Chapter-33--Revenue-and-contract-costs/33-5-Revenue-and-related-costs-ASC-606-considerations-for-private-companies.html
- Baker Tilly, Significant revenue recognition disclosure changes for nonpublic companies (minimum disclosures for timing of transfer, contract balances, judgments): https://www.bakertilly.com/insights/disclosure-updates-for-nonpublic-companies
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