Accounting for Incremental Costs of Obtaining a Contract

Incremental costs of obtaining a contract are expenses a company incurs only when a new customer agreement is successfully secured. These are costs that would not have existed otherwise. This concept is part of the revenue recognition framework in Accounting Standards Codification (ASC) 606, which dictates how revenue and its associated costs are recognized.

Identifying Qualifying Costs

The test for a qualifying cost is whether it is truly incremental, meaning it would not have been incurred “but for” the company obtaining the contract. If an expense is paid regardless of the outcome, it does not qualify. The specific accounting treatment for these expenditures is governed by ASC 340-40.

Certain costs clearly meet the incremental definition. The most common example is a sales commission paid to an employee or an external agent only after a customer signs the contract. If the commission is contingent upon the successful execution of the agreement, it qualifies. Another example is legal fees structured to be payable only upon the successful completion of contract negotiations.

Many costs from the sales process do not qualify because they are incurred whether or not a contract is obtained. A salesperson’s base salary is not an incremental cost, as it is paid regardless of their success. General marketing, advertising, travel for sales meetings, proposal preparation expenses, and administrative overhead are also excluded because they are not tied to winning one specific contract.

Bonuses or commissions tied to multiple factors require more judgment. If a sales manager receives a bonus based on a regional sales target, that bonus is generally not an incremental cost for any single contract. This is because obtaining one specific contract is only a part of a larger set of performance goals. The cost would not be considered a direct result of winning that individual agreement.

Capitalization of Contract Costs

Once identified, an incremental cost cannot be immediately expensed. Instead, accounting rules require the cost to be capitalized, meaning it is recorded as an asset on the company’s balance sheet. This is done if the company expects to recover the cost, which is usually through the revenue generated by the contract.

The reason for capitalizing these costs is the matching principle, which aligns expenses with the revenues they help generate. By capitalizing a sales commission, the cost is not recognized all at once when paid. It is instead matched against the revenue earned over the life of the contract, providing a more accurate picture of profitability.

Expenses that do not qualify as incremental, such as a salesperson’s salary or marketing efforts, are recognized as expenses in the period they are incurred. Capitalizing the incremental costs creates an asset on the balance sheet that represents the future economic benefit from the secured customer relationship.

To capitalize the cost, a journal entry is made to debit an asset account, such as “deferred contract acquisition costs,” and credit cash or a liability like “commissions payable.” This entry places the cost on the balance sheet to be expensed in future periods.

Amortization of the Asset

After a cost is capitalized as an asset, it must be systematically expensed over time through a process called amortization. Amortization allocates the capitalized cost to the income statement in a way that aligns with the transfer of goods or services to the customer. The asset is gradually reduced, and a corresponding expense is recorded in each accounting period.

The first step is determining the amortization period, which should reflect the time the company expects to provide goods or services to the customer. This often aligns with the initial contract term but must also include anticipated renewals if there is an expectation the relationship will extend. The goal is to match the expense with the entire revenue stream generated by the cost.

Next, the company must select a systematic and rational amortization method that reflects the pattern of revenue recognition. A common approach is the straight-line method, where an equal amount is expensed in each period. Alternatively, a company might use a method based on the proportion of revenue recognized in a period relative to the total expected revenue.

For example, if a company pays a $10,000 commission for a five-year service contract with no expected renewals, it would capitalize the $10,000. Using a straight-line basis, it would recognize $2,000 in amortization expense each year for five years. This entry debits amortization expense and credits the capitalized asset, reducing its balance to zero over the contract term.

Practical Expedient and Impairment Considerations

The accounting standards provide a simplification known as the practical expedient. A company may choose to expense the incremental costs of obtaining a contract when incurred if the amortization period would have been one year or less. This option allows companies to bypass capitalizing and amortizing short-term contract costs, but the election must be applied consistently to similar contracts.

Capitalized costs are subject to ongoing evaluation for impairment. An impairment loss must be recognized if the asset’s carrying amount is greater than the remaining consideration the company expects to receive from the customer, less any future costs. This could happen if a customer’s financial health declines or if the contract is expected to terminate early.

An impairment test is triggered by events or changes in circumstances indicating the asset’s value may not be recoverable. If an impairment is identified, the company must write down the asset to its recoverable amount. This is done by recording an impairment loss on the income statement, which accelerates the expense recognition. This ensures that the asset on the balance sheet does not overstate the future economic benefits expected from the contract.