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
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
- 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).
- The costs generate or enhance resources of the entity that will be used in satisfying (or continuing to satisfy) performance obligations in the future.
- 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
- Direct labor (for example, salaries and wages of employees who provide the promised services directly to the customer)
- Direct materials (for example, supplies used in providing the promised services to a customer)
- 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)
- Costs that are explicitly chargeable to the customer under the contract
- 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:
- General and administrative costs (unless those costs are explicitly chargeable to the customer under the contract…)
- Costs of wasted materials, labor, or other resources to fulfill the contract that were not reflected in the price of the contract
- Costs that relate to satisfied performance obligations (or partially satisfied performance obligations) in the contract (that is, costs that relate to past performance)
- 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?
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.