The ASC 606 (revenue recognition) transition: cost capitalization

While we have been focused on the transformational changes in revenue recognition that Accounting Standards Codification (ASC) 606 has brought about, the standard itself also addresses costs associated with obtaining and fulfilling revenue from contracts with customers. As with revenue recognition itself, the codification has never comprehensively addressed costs in connection with contracts. Often, the guidance has been found within the industry sections, or other disparate sections of the codification. The new standard seeks to comprehensively address the issue.

Contract cost guidance has been added to ASC 606 through changes in specific subtopics.

Incremental costs of obtaining a contract

Briefly stated, incremental costs of obtaining a contract should be recognized as an asset if the entity expects to recover such costs, through execution of the contract. The incremental costs are those identified with obtaining a specific contract which otherwise would not have been incurred. A typical example of such a cost would be a sales commission. However, there could be many others. As long as they directly related to the contract they should be capitalized.

The standard provides a practical expedient, wherein an entity may recognize such costs as incurred, if the amortization period of such asset is less than one year.

Amortization should be provided on the asset in a manner that reflects the transfer of goods or services to the customer. The amortization period should be adjusted if the entity anticipates a significant change in the timing of the transfer. Any such change should be accounted for as a change in estimate, i.e. prospectively.

If an entity determines that the remaining balance of the unamortized costs exceeds the remaining amount of consideration to be received on the contract, less the remaining amount of costs (not yet recognized) to be incurred in fulfilling the contract (the remaining margin), the entity shall recognize an impairment charge in profit or loss.

In determining the remaining amount of consideration, the entity shall consider the guidance related to determining the transaction price, without regard to the constraining estimate of variable consideration guidance, adjusted to reflect the credit risk of the customer.

Any impairment loss to the asset will be measured after the entity has considered impairment losses related to other contract assets measured in accordance with the standard.

Costs to fulfill a contract

In general, an entity should recognize an asset related to costs incurred to fulfill a contract if the costs meet all of the following:

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.1

Examples of such costs include:

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)2

Entities should expense, as incurred, general and administrative costs, costs of wasted material or labor not reflected in the cost of the contract, costs related to past performance, and costs which cannot be identified as associated with a performance obligation.

Other costs may be in the nature of costs associated with other subtopics, such as:

1. Inventory costs
2. Preproduction costs of long term supply agreements
3. Internal use software
4. Property, plant and equipment
5. Development costs of software to be sold, leased or marketed

Entities will need to carefully assess the nature of the costs being incurred in connection with a specific contract and measure accordingly.

As with the other elements of implementing ASC 606, entities will face changes and may see differences in historical accounting, especially with respect to previous accounting for the costs of obtaining a contract. In these cases, an entity’s internal controls over financial reporting (ICFR) should be adapted as necessary to address the decisions made related to such costs, including how they have been identified and distinguished from routine costs that would have been incurred by the entity whether or not the contract was obtained.

For more information on revenue recognition, or to learn how Baker Tilly’s specialists can help, contact our team.

[1] ASC 340-40-25-5

[2] ASC 340-40-25-7

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