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Reporting entities often incur costs to fulfill their obligations under a contract once it is obtained, but before transferring goods or services to the customer. Some costs could also be incurred in anticipation of winning a contract. The guidance in the revenue standard for costs to fulfill a contract only applies to those costs not addressed by other standards. For example, inventory costs would be covered under ASC 330, Inventory. Costs that are required to be expensed in accordance with other standards cannot be recognized as an asset under the revenue standard. Fulfillment costs not addressed by other standards qualify for capitalization if the following criteria are met.

Excerpt from ASC 340-40-25-5

  1. The costs relate directly to a contract or an anticipated contract that the entity can specifically identify (for example, costs relating to services to be provided under the 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 continuing to satisfy) performance obligations in the future.
  3. The costs are expected to be recovered.

Fulfillment costs that meet all three of the above criteria are required to be recognized as an asset; expensing the costs as they are incurred is not permitted.
Costs that relate directly to a contract include the following.

Excerpt from ASC 340-40-25-7

  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. Allocation 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).

Judgment is needed to determine the costs that should be recognized as assets in some situations. Some of the costs listed above (for example, direct labor and materials) are straightforward and easy to identify. However, determining costs that should be allocated to a contract could be more challenging.
Certain costs might relate directly to a contract, but neither generate nor enhance resources of a reporting entity, nor relate to the satisfaction of future performance obligations.

Excerpt from ASC 340-40-25-8

An entity shall recognize the following costs as expenses when incurred:
  1. General and administrative costs (unless those costs are explicitly chargeable to the customer under the contract…)
  2. Costs of wasted materials, labor, or other resources to fulfill the contract that were not reflected in the price of the contract
  3. Costs that relate to satisfied performance obligations (or partially satisfied performance obligations) in the contract (that is, costs that relate to past performance)
  4. Costs for which an entity cannot distinguish whether the costs relate to unsatisfied performance obligations or to satisfied performance obligations (or partially satisfied performance obligations).

It can be difficult in some situations to determine whether incurred costs relate to satisfied performance obligations or to obligations still remaining. Costs that relate to satisfied or partially satisfied performance obligations are expensed as incurred. This is the case even if the related revenue has not been recognized (for example, because it is variable consideration that has been constrained). Costs cannot be deferred solely to match costs with revenue, nor can they be deferred to normalize profit margins. A reporting entity should expense all incurred costs if it is unable to distinguish between those that relate to past performance and those that relate to future performance.
Costs to fulfill a contract are only recognized as an asset if they are recoverable, similar to costs to obtain a contract. Refer to RR 11.2.1 for further discussion of assessing recoverability.
Question RR 11-6 addresses whether costs to fulfill a contract can be deferred to achieve a consistent profit margin.
Question RR 11-6
Contractor utilizes an output method (engineering surveys) to measure progress of construction services for which control transfers over time. In the first reporting period, Contractor determines that 35% of the contract has been completed based on the engineering survey and accordingly, recognizes revenue equal to 35% of the estimated transaction price. In the same period, Contractor incurs 45% of the estimated total costs to fulfill the contract. Can Contractor defer a portion of the costs incurred to achieve a consistent profit margin throughout the contract?
PwC response
No. Costs cannot be deferred solely to match costs with revenue or to achieve a consistent profit margin throughout the contract. Only costs to fulfill the contract that are capitalizable under other standards or meet the criteria for capitalization in the revenue standard (refer to RR 11.3.1) should be capitalized. The use of an output method to measure progress can result in different period to period profit margins unlike an input method based on costs incurred; however, the total profit margin on the contract will be the same under either method.

11.3.1 Recognition model overview

Figure RR 11-2 summarizes accounting for costs to fulfill a contract.
Figure RR 11-2
Recognition model overview

11.3.2 Learning curve costs

Learning curve costs are costs a reporting entity incurs to provide a service or produce an item in early periods before it has gained experience with the process. Over time, the reporting entity typically becomes more efficient at performing a task or manufacturing a good when done repeatedly and no longer incurs learning curve costs for that task or good. Such costs usually consist of labor, overhead, rework, or other special costs that must be incurred to complete the contract other than research and development costs.
Judgment is required to determine the accounting for learning curve costs. Learning curve costs incurred for a single performance obligation that is satisfied over time are recognized in cost of sales, but they may need to be considered in the measurement of progress toward satisfying a performance obligation, depending on the nature of the cost. For example, a reporting entity applying a cost-to-cost measure of progress might recognize more revenue in earlier periods due to the higher costs incurred earlier in the contract.
Learning curve costs incurred for a performance obligation satisfied at a point in time should be assessed to determine if they are addressed by other standards (such as inventory). Learning curve costs not addressed by other standards are unlikely to meet the criteria for capitalization under the revenue standard, as such costs generally do not relate to future performance obligations. For example, a reporting entity may promise to transfer multiple units under a contract in which each unit is a separate performance obligation satisfied at a point in time. The costs to produce each unit would be accounted for under inventory guidance and recognized in cost of sales when control of the inventory transfers. As a result, the margin on each individual unit could differ if the costs to produce units earlier in the contract are greater than the costs to produce units later in the contract.

11.3.3 Set-up and mobilization costs

Set-up and mobilization costs are direct costs typically incurred at a contract's inception to enable a reporting entity to fulfill its obligations under the contract. For example, outsourcing reporting entities often incur costs relating to the design, migration, and testing of data centers when preparing to provide service under a new contract. Set-up costs may include labor, overhead, or other specific costs. Some of these costs might be addressed under other standards, such as property, plant, and equipment. Management should first assess whether costs are addressed by other standards and if so, apply that guidance.
Mobilization costs are a type of set-up cost incurred to move equipment or resources to prepare to provide the goods or services in an arrangement. Costs incurred to move newly acquired equipment to its intended location could meet the definition of the cost of an asset under property, plant, and equipment guidance. Costs incurred subsequently to move equipment for a future contract that meet the criteria in RR 11.3 are costs to fulfill a contract and therefore assessed to determine if they qualify to be recognized as an asset.
Certain pre-production costs related to long-term supply arrangements are addressed by specific guidance (that is, ASC 340-10, Other Assets and Deferred Costs—Overall). As such, costs in the scope of ASC 340-10 should be assessed under that guidance to determine whether they should be capitalized or expensed. Management may need to apply judgment in assessing the guidance that applies to pre-production costs (for example, ASC 340-10, ASC 340-40, Other Assets and Deferred Costs—Contracts With Customers, ASC 730, Research and Development). Refer to PPE 1.5.2 for a discussion of ASC 340-10 and RR 3.6.1 for further discussion of pre-production activities.
Example RR 11-6 illustrates the accounting for set-up costs. This concept is also illustrated in Example 37 of the revenue standard (ASC 340-40-55-5 through ASC 340-40-55-9).
EXAMPLE RR 11-6

Set-up costs – technology industry
TechCo enters into a contract with a customer to track and monitor payment activities for a five-year period. A prepayment is required from the customer at contract inception. TechCo incurs costs at the outset of the contract consisting of uploading data and payment information from existing systems. The ongoing tracking and monitoring is automated after customer set up. There are no refund rights in the contract.
How should TechCo account for the set-up costs?
Analysis
TechCo should recognize the set-up costs incurred at the outset of the contract as an asset since they (1) relate directly to the contract, (2) enhance the resources of the company to perform under the contract, and relate to future performance, and (3) are expected to be recovered.
An asset would be recognized and amortized on a systematic basis consistent with the pattern of transfer of the tracking and monitoring services to the customer. The prepayment from the customer should be included in the transaction price and allocated to the performance obligations in the contract (that is, the tracking and monitoring services).

11.3.4 Costs related to wasted materials

Fulfillment costs relating to excessive resources, wasted or spoiled materials, and unproductive labor costs (that is, costs not otherwise anticipated in the contract price) might arise due to delays, changes in project scope, or other factors. Such costs should be expensed as incurred as illustrated in Example RR 11-7. They differ from learning curve costs, which are typically reflected in the price of the contract.
EXAMPLE RR 11-7

Costs to fulfill a contract – construction industry
Construction Co enters into a contract with a customer to build an office building. Construction Co incurs directly related mobilization costs to bring heavy equipment to the location of the site. During the build phase of the contract, Construction Co incurs direct costs related to supplies, equipment, material, and labor. Construction Co also incurs costs related to wasted materials purchased in connection with the contract that were not anticipated in the contract price. Construction Co expects to recover all incurred costs under the contract.
How should Construction Co account for the costs?
Analysis
Construction Co should recognize an asset for the mobilization costs as these costs (1) relate directly to the contract, (2) enhance the resources of the reporting entity to perform under the contract and relate to satisfying a future performance obligation, and (3) are expected to be recovered.
The direct costs incurred during the build phase are accounted for in accordance with other standards if those costs are in the scope of those standards. Certain supplies and materials, for example, might be capitalized in accordance with inventory guidance. The equipment might be capitalized in accordance with property, plant, and equipment guidance. Any other direct costs associated with the contract that relate to satisfying performance obligations in the future and are expected to be recovered are recognized as an asset.
Construction Co should expense the costs of wasted materials as incurred.
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