ASC 340-20: Accounting for Costs to Obtain a Contract

Accounting Standards Codification (ASC) 340-20 provides guidance for the accounting of costs a company incurs to obtain a contract with a customer. The primary objective is to ensure that the recognition of these costs aligns with the revenue generated from the contracts they helped secure. By capitalizing certain costs and recognizing them over time, the standard aims to create a more accurate depiction of a contract’s profitability. This approach prevents the front-loading of expenses, which could distort financial reporting.

This standard specifically addresses the treatment of incremental costs of obtaining a contract. It establishes a framework for identifying which expenditures should be recorded as an asset on the balance sheet versus which should be treated as an expense in the period they are incurred.

Identifying Capitalizable Costs

The core principle for determining if a cost can be capitalized under ASC 340-20 revolves around whether it is an “incremental cost.” An incremental cost is defined as an expense that a company would not have incurred if the contract had not been successfully obtained. The most straightforward example is a sales commission paid to an employee or an external agent that is contingent upon a customer signing a contract.

In contrast, many costs associated with sales and marketing efforts do not meet this strict definition. For instance, the fixed annual salary of a salesperson is not an incremental cost because it is paid regardless of whether any specific contract is won. Similarly, general marketing and advertising expenses, legal fees for drafting a standard contract template, or costs for preparing a bid are expensed as incurred.

The standard requires that for a cost to be capitalized, the company must also expect to recover it. The guidance also provides a practical expedient: if the amortization period for a capitalized cost would be one year or less, the company can elect to expense the cost as it is incurred.

Capitalization and Amortization of Contract Costs

Once a cost is identified as a capitalizable incremental cost of obtaining a contract, it is recognized as an asset on the company’s balance sheet. This asset represents the future economic benefit the company expects to receive from the customer contract. The asset is typically classified under a heading such as “Other Assets” or “Deferred Contract Costs.”

The amortization of this asset is the process of systematically expensing the capitalized cost over time. According to ASC 340-20, the asset must be amortized on a basis that is consistent with the pattern of transfer of the goods or services to the customer. This means the expense should be recognized in the income statement in the same periods that the related revenue is recognized. For a service contract where revenue is recognized straight-line, the asset would also be amortized on a straight-line basis.

Determining the appropriate amortization period requires significant judgment. The period is not limited to the initial term of the contract if it is expected to be renewed and the capitalized cost relates to the goods or services to be provided during those renewal periods. For example, if a company pays a commission on a three-year contract but has substantial evidence that customers typically renew for an additional two years, the amortization period could be five years.

Impairment of Capitalized Costs

After capitalizing a contract cost asset, a company must periodically evaluate it for impairment. An impairment loss must be recognized if the carrying amount of the asset—its original cost minus any accumulated amortization—is greater than the value the company expects to realize from it. This evaluation is triggered when facts or circumstances indicate that the asset’s value may have diminished.

The impairment test involves a specific calculation. The company must compare the carrying amount of the asset to the remaining amount of consideration it expects to receive from the customer, less the estimated costs related to providing the remaining goods or services. If the carrying amount is higher, an impairment loss equal to the difference is recorded.

For example, consider a company that capitalized a $10,000 sales commission. After one year, the carrying amount is $8,000. If the company now learns the customer is facing financial difficulty and revises its estimate of the remaining recoverable consideration to be only $5,000, it would recognize an impairment loss of $3,000.

Once an impairment loss is recorded, it cannot be reversed in a future period.

Presentation and Disclosure Requirements

The asset recognized for the incremental costs of obtaining a contract is presented on the balance sheet. It is commonly included within “Other non-current assets” or a similar category, separate from assets like property, plant, and equipment.

The amortization expense associated with this asset is typically recognized within the income statement as part of selling, general, and administrative (SG&A) expenses. Similarly, if an impairment loss is recognized, it is also generally included within the same expense category.

Companies are required to provide specific disclosures in the footnotes to their financial statements. These disclosures must describe the judgments made in determining the amount of costs incurred to obtain a contract. They must also explain the method used to amortize these costs, specifying whether it is on a straight-line basis or another systematic approach.

A quantitative disclosure is also required, which involves a reconciliation of the beginning and ending balances of the capitalized contract cost asset. This reconciliation shows the initial capitalized costs, the amortization expense for the period, and any impairment losses recognized.