ASC 340, Other Assets and Deferred Costs, covers costs that sit on the balance sheet until they are used. Two pieces matter in most audits. Subtopic 340-40, Contracts with Customers, which came with ASC 606, governs the costs of obtaining and fulfilling a customer contract, the source of capitalized sales commissions and set-up costs. The balance sheet also carries other deferred costs and prepaid expenses, which follow the general rule of recognizing the cost as the benefit is consumed.
This page covers 340-40 in detail and the audit questions that follow. For the revenue side, see ASC 606 revenue recognition.
Which costs of obtaining a contract are capitalized?
An entity recognizes as an asset the incremental costs of obtaining a contract with a customer if it expects to recover them (ASC 340-40-25-1). Incremental costs are those the entity would not have incurred if the contract had not been obtained, with a sales commission as the standard example (25-2). Costs that would have been incurred regardless of whether the contract was won, such as legal due diligence, travel to present a proposal, or a discretionary bonus pool tied to company profitability, are expensed as incurred unless they are explicitly chargeable to the customer regardless of whether the contract is obtained (25-3).
The standard's own example has a consulting firm winning a bid. It incurs $15,000 of external legal fees, $25,000 of travel, and $10,000 in commissions to sales employees. Only the $10,000 commission is capitalized. The legal and travel costs would have been incurred win or lose, and annual discretionary bonuses to sales supervisors, driven by profitability and individual performance, are not attributable to an identifiable contract.
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 record is one year or less (25-4). The test is the amortization period, not the contract term. KPMG's guidance gives the key trap: if a one-year contract is expected to renew and the entity will not pay commensurate commissions on renewal, the commission on the initial contract is amortized over more than one year, and the expedient is unavailable.
Which costs of fulfilling a contract are capitalized?
Costs to fulfill a contract that are not in the scope of another Topic (inventory under ASC 330, PP&E under ASC 360, internal-use software under ASC 350-40, and so on) are capitalized only if all three conditions in 340-40-25-5 are met:
- the costs relate directly to a contract or a specifically anticipated contract, including direct labor, direct materials, allocated costs that relate directly to the contract, and costs explicitly chargeable to the customer
- the costs generate or enhance resources of the entity that will be used in satisfying performance obligations in the future
- the costs are expected to be recovered
Specifically anticipated contracts include renewals and unpriced change orders expected to be approved. Under 340-40-25-8, the entity expenses general and administrative costs unless they are explicitly chargeable under the contract, costs of wasted materials, labor or other resources, costs that relate to satisfied or partially satisfied performance obligations, and costs for which the entity cannot distinguish whether they relate to unsatisfied or satisfied performance obligations. Set-up costs for a managed-services contract, such as building customer accounts or loading data, are a common capitalized fulfillment cost.
How is the asset amortized?
The asset is amortized on a systematic basis consistent with the transfer to the customer of the goods or services to which it relates. That can include goods or services under a specifically anticipated contract, such as expected renewals (340-40-35-1). A significant change in the expected timing of transfer updates the amortization as a change in estimate under ASC 250 (35-2). See ASC 250.
Illustration (illustrative)
A software company signs a three-year, $120,000 contract. It pays a sales rep a commission of 8% of the contract value, $9,600, at signing. The company pays only 2% on renewals, which is not commensurate with the initial 8%, and its experience shows an average customer relationship of 5 years. The asset therefore relates to the initial contract and to anticipated renewals, and the one-year expedient is not available. If the services transfer evenly, straight-line amortization over 5 years is $9,600 / 5 = $1,920 per year. At the end of the first year, the carrying amount is $9,600 - $1,920 = $7,680.
Where the amortization period is a judgment, the audit file should show the support, such as customer retention data, rather than an assumed period.
How is impairment tested?
An impairment loss is recognized to the extent the carrying amount of the contract cost asset exceeds the remaining amount of consideration the entity expects to receive for the related goods or services (including consideration received but not yet recognized as revenue), less the costs that relate directly to providing them and have not yet been expensed (35-3). The consideration estimate uses the transaction price principles, without the variable-consideration constraint, adjusted for the customer's credit risk, and includes expected renewals and extensions with the same customer (35-4). Impairments of related assets under other Topics are recognized first (35-5). A reversal of an impairment loss is not recognized (35-6).
What must be disclosed?
Disclosures under 340-40-50 include the closing balances of capitalized contract cost assets by main category, the amount of amortization and impairment losses recognized in the period, and the judgments made in determining the amounts, including the method used to determine amortization. The disclosures sit alongside the ASC 606 disclosures. The ASC 606 and lease disclosure checklist is a starting point.
How do prepaid expenses fit in?
A prepaid expense is a cost paid in advance for benefits to be received in future periods, recognized as an expense as the benefit is consumed. Typical examples are insurance premiums, rent, software subscriptions and service contracts. A prepaid is a current asset when the benefit will be used within one year or the operating cycle, whichever is longer, and noncurrent otherwise. The prepaid expense schedule template and prepaid expenses entry cover the audit file. For capitalized contract costs, the distinction from a prepaid is that the asset exists because of a customer contract.
What do auditors test?
These are practice procedures rather than steps the standard names:
- Obtain the commission plan and read the terms. Identify which payments are incremental (commission on a signed contract) and which are not (annual bonus pools, draws, accelerators tied to company results).
- Agree additions to a rollforward of capitalized costs to payroll or commission reports and to signed contracts.
- Test the amortization period against retention data and renewal commission terms.
- Recompute amortization and check that terminated contracts are written off.
- Test impairment where a contract has been canceled or a customer is at risk.
- Check that the one-year expedient is applied consistently and disclosed as an accounting policy.
- For prepaids, recompute the release and check that the asset is not carrying expired coverage.
Frequently asked questions
Are sales commissions always capitalized?
Only if they are incremental costs of obtaining a contract that the entity expects to recover, and the one-year practical expedient does not apply. Commissions on a contract with an amortization period of one year or less may be expensed under the expedient.
Can a company apply the practical expedient if renewals are expected?
Not when anticipated renewals extend the amortization period beyond one year, for example when renewal commissions are not commensurate with the initial commission.
Are set-up costs capitalized?
If they relate directly to a contract, generate or enhance resources that will satisfy future performance obligations, and are expected to be recovered, and no other Topic covers them.
Can a contract cost impairment be reversed?
No. 340-40-35-6 prohibits reversal.
Do prepaid expenses fall under ASC 340-40?
No. They are costs paid for future benefits and sit outside the contracts-with-customers subtopic.
Sources
- FASB, Accounting Standards Codification Subtopic 340-40, Other Assets and Deferred Costs - Contracts with Customers: 25-1 through 25-8, 35-1 through 35-6, 50-1 through 50-3, Examples 1 and 2. https://asc.fasb.org
- KPMG, Handbook: Revenue recognition (2025), chapter 12, Contract costs, including the excerpted ASC 340-40 text and the interpretive responses on the practical expedient and renewals.
- FASB, ASU 2014-09, Revenue from Contracts with Customers, which introduced Subtopic 340-40.
- FASB, ASC 210-10-45, balance sheet classification of current assets.
Related
- ASC 606 revenue recognition
- ASC 606 five-step model
- Contract asset and contract liability
- Prepaid expenses
- Prepaid expense schedule template
- Revenue recognition audit procedures
- ASC 606 allocation calculator
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