13.3 Costs of Fulfilling a Contract

ASC 340-40

15-3 The guidance in this Subtopic applies to the costs incurred in fulfilling a contract with a customer within the scope of Topic 606 on revenue from contracts with customers, unless the costs are within the scope of another Topic or Subtopic, including, but not limited to, any of the following:

Topic 330 on inventory
Paragraphs 340-10-25-1 through 25-4 on preproduction costs related to long-term supply arrangements
Subtopic 350-40 on internal-use software
Topic 360 on property, plant, and equipment
Subtopic 985-20 on costs of software to be sold, leased, or otherwise marketed.

25-5 An entity shall recognize an asset from the costs incurred to fulfill a contract only if those costs meet all of the following criteria:

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).
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.
The costs are expected to be recovered.

25-6 For costs incurred in fulfilling a contract with a customer that are within the scope of another Topic (for example, Topic 330 on inventory; paragraphs 340-10-25-1 through 25-4 on preproduction costs related to long-term supply arrangements; Subtopic 350-40 on internal-use software; Topic 360 on property, plant, and equipment; or Subtopic 985-20 on costs of software to be sold, leased, or otherwise marketed), an entity shall account for those costs in accordance with those other Topics or Subtopics.

25-7 Costs that relate directly to a contract (or a specific anticipated contract) include any of the following:

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)
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)
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).

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, in which case an entity shall evaluate those costs in accordance with paragraph 340-40-25-7)
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).

The flowchart below illustrates the process that entities should use in applying the guidance in ASC 340-40-25-5 through 25-8 to determine how to account for costs of fulfilling a contract with a customer.

The revenue standard does not modify accounting for fulfillment costs that are addressed by other applicable U.S. GAAP, but it does create guidance on fulfillment costs that are outside the scope of other Codification topics, including costs related to certain preproduction activities (i.e., those not covered by other applicable standards).

Because the FASB and IASB did not intend to reconsider cost guidance altogether, the revenue standard focuses on costs of fulfilling a contract that are not within the scope of another standard. Accordingly, if costs are within the scope of another standard and that standard requires them to be expensed, it is not possible to argue that they should be capitalized in accordance with ASC 340-40. In addition, only costs directly related to a contract or anticipated contract with a customer are within the scope of ASC 340-40. Costs not directly related to a contract or anticipated (specified) contract should not be evaluated for capitalization under ASC 340-40. Further, when determining whether fulfillment costs are within the scope of ASC 340-40, the reporting entity should also consider its relationship with the other entity in the arrangement. That is, if the reporting entity incurs costs and transfers consideration to another entity, and that other entity also transfers consideration to the reporting entity in exchange for goods or services, the reporting entity should consider whether the consideration exchanged between the two parties should be accounted for as (1) consideration payable to a customer under ASC 606 or (2) consideration received from a vendor under ASC 705-20. For additional discussion, see Sections 3.2.8 and 6.6.5.

The boards’ intent in developing this guidance was to develop a clear objective for recognizing and measuring an asset arising from the costs incurred to fulfill a contract; therefore, the boards decided that the costs must be directly related to a contract or anticipated contract to be included in the cost of the asset.

Connecting the Dots

Stakeholders have questioned whether costs incurred for an anticipated contract (e.g., costs for design and development or nonrecurring engineering) (1) would be within the scope of ASC 340 and therefore could be capitalized or (2) should be expensed in accordance with ASC 730. This issue is similar to the TRG’s discussion of preproduction activities (see Section 13.3.4); however, the costs incurred for an anticipated contract would pertain to a contract that is not yet obtained and whose terms might not yet be known. Factors for an entity to consider in determining whether the costs should be capitalized include, but are not limited to, (1) the likelihood or certainty that the entity will obtain the contract, (2) the likelihood that the costs will be recovered under the specific anticipated contract, (3) whether the costs create or enhance an asset that will be transferred to the customer once the entity obtains the contract (such costs could be capitalizable under other guidance), and (4) whether the costs are considered to be costs associated with R&D and would therefore be within the scope of ASC 730 and expensed as incurred. An entity will need to carefully consider the facts and circumstances of the arrangement in determining the appropriate treatment of costs incurred before a contract was obtained.

Example 2 in ASC 340-40 illustrates how to account for costs of fulfilling a contract.

ASC 340-40

Example 2 — Costs That Give Rise to an Asset

55-5 An entity enters into a service contract to manage a customer’s information technology data center for five years. The contract is renewable for subsequent one-year periods. The average customer term is seven years. The entity pays an employee a $10,000 sales commission upon the customer signing the contract. Before providing the services, the entity designs and builds a technology platform for the entity’s internal use that interfaces with the customer’s systems. That platform is not transferred to the customer but will be used to deliver services to the customer.

Costs to Fulfill a Contract

55-7 The initial costs incurred to set up the technology platform are as follows:

55-8 The initial setup costs relate primarily to activities to fulfill the contract but do not transfer goods or services to the customer. The entity accounts for the initial setup costs as follows:

Hardware costs — accounted for in accordance with Topic 360 on property, plant, and equipment
Software costs — accounted for in accordance with Subtopic 350-40 on internal-use software
Costs of the design, migration, and testing of the data center — assessed in accordance with paragraph 340-40-25-5 to determine whether an asset can be recognized for the costs to fulfill the contract. Any resulting asset would be amortized on a systematic basis over the seven-year period (that is, the five-year contract term and two anticipated one-year renewal periods) that the entity expects to provide services related to the data center.

55-9 In addition to the initial costs to set up the technology platform, the entity also assigns two employees who are primarily responsible for providing the service to the customer. Although the costs for these two employees are incurred as part of providing the service to the customer, the entity concludes that the costs do not generate or enhance resources of the entity (see paragraph 340-40-25-5(b)). Therefore, the costs do not meet the criteria in paragraph 340-40-25-5 and cannot be recognized as an asset using this Topic. In accordance with paragraph 340-40-25-8, the entity recognizes the payroll expense for these two employees when incurred.

13.3.1 Variable Consideration and Uncertain Transaction Price

As noted above, an entity would need to be able to demonstrate whether any capitalized costs are recoverable. That is, the entity’s contract with a customer needs to generate sufficient profit to recover any capitalized costs. Otherwise, no asset should be recorded or a recorded asset would be impaired (see Section 13.4.2). Determining whether capitalized costs are recoverable may be challenging when the contract contains variable consideration rather than fixed consideration.

When an entity enters into a contract with a customer to provide goods or services for variable consideration and the transaction price is fully or partially constrained at the time the customer obtains control of the goods or services, the entity may incur an up-front loss until the uncertainty associated with the variable consideration is resolved. That is, the amount of the asset(s) derecognized or fulfillment costs recognized exceeds the amount of revenue to be recognized on the date the entity satisfies its performance obligation(s) because of the application of the constraint on variable consideration.

An entity should not defer costs associated with transferred goods or services in a contract when variable consideration is fully or partially constrained. Rather, an entity should expense costs that are not eligible for capitalization under other authoritative literature (e.g., ASC 330 on inventory; ASC 360 on property, plant, and equipment; or ASC 985-20 on costs of software to be sold, leased, or otherwise marketed) unless (1) such costs meet the criteria to be capitalized in accordance with ASC 340-401 or (2) the resolution of an uncertainty giving rise to the constraint on variable consideration will result in the entity’s recovery of an asset (e.g., a sales return).

In assessing whether costs meet the criteria to be capitalized as fulfillment costs, an entity should consider the guidance in ASC 340-40-25-5, which states that an entity should recognize an asset from the costs incurred to fulfill a contract only if all of the following criteria are met:

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).
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.
The costs are expected to be recovered.

Since costs attributed to a satisfied performance obligation do not generate or enhance resources that the entity will use in satisfying, or continuing to satisfy, future performance obligations, such costs do not meet criterion (b) and would not be eligible for capitalization under ASC 340-40.

Example 13-9

Entity A, a manufacturer, sells goods to Customer B, a distributor, for resale to B’s customers. The manufacturer is required to recognize revenue when, after consideration of the indicators of control in ASC 606-10-25-30, it determines that control of goods has been transferred to the distributor.

Entity A enters into a contract with B to sell goods with a cost basis of $180,000 for consideration of $200,000. However, the goods have a high risk of obsolescence, which may cause A to provide rebates or price concessions to B in the future (i.e., the transaction price is variable). The contract does not include a provision for product returns, and A does not expect to accept any return of obsolete goods.

Entity A adjusts (i.e., constrains) the transaction price and concludes that $170,000 is the amount of consideration that is probable of not resulting in a significant revenue reversal. When control of the goods is transferred to B, A recognizes revenue of $170,000 (the constrained transaction price) and costs of $180,000.2 As a result, A incurs a loss of $10,000.

13.3.2 Initial Losses and Expected Future Profits

Questions arise about whether losses incurred on an initially satisfied performance obligation can be capitalized when an entity is expected to generate profits on the sale of optional goods or services to a customer. This scenario is illustrated in the example below.

Example 13-10

Entity E’s business model includes the sale of (1) equipment and (2) parts needed to maintain that equipment. It is possible for customers to source parts from other suppliers, but the regulatory environment in which E’s customers operate is such that customers will almost always choose to purchase parts from E (the original equipment manufacturer). The spare parts are needed for the equipment to properly function for its expected economic life.

Entity E’s business model is to sell the equipment at a significantly discounted price (less than the cost to manufacture the equipment) when E believes that doing so is likely to secure a profitable stream of parts sales. This initial contract is only for the equipment; it does not give E any contractual right to require that customers subsequently purchase any parts. However, E’s historical experience indicates that (1) customers will virtually always subsequently purchase parts and (2) the profits on the parts sales will more than compensate for the discount given on the equipment.

The equipment has a cost of $200 and would usually be sold for a profit. However, the equipment is sold at a discounted price of $150 if subsequent parts sales are expected.

When the equipment is sold for $150, E is not permitted to defer an element of the cost of $200 to reflect its expectation that this sale will generate further, profitable sales in the future.

In accordance with ASC 340-40-25-6, when the costs of fulfilling a contract are within the scope of another standard, they should be accounted for in accordance with that standard. In the circumstances described, the cost of $200 is within the scope of ASC 330 and must be expensed when the equipment is sold. Further, ASC 340-40-25-8(c) requires “[c]osts that relate to satisfied performance obligations (or partially satisfied performance obligations) in the contract (that is, costs that relate to past performance)” to be expensed when incurred.

Although E expects customers to purchase additional parts that will give rise to future profits, those additional purchases are at the customer’s option and are not part of the contract to sell the equipment. Since E has satisfied its obligation to deliver the equipment, it is required to recognize revenue of $150 and the $200 cost in full.

Consequently, a loss of $50 arises on the initial sale of the equipment.

Connecting the Dots

In November 2015, TRG members discussed scenarios in which an entity sells goods or services to a customer at a loss with a strong expectation of profit on future orders from that customer (e.g., exclusivity or sole provider contractual terms). TRG members agreed that if those further purchases are optional, the underlying goods or services would not be considered promised goods or services in the initial contract with the customer; rather, any such options would be evaluated for the existence of a material right. For further discussion, see Chapter 11.

The above issue is addressed in TRG Agenda Paper 49. For additional information and Deloitte’s summary of issues discussed in the TRG Agenda Papers and Implementation Q&As, see Appendix C.

13.3.3 Contracts Satisfied Over Time

ASC 340-40-25-8(c) requires fulfillment costs attributed to satisfied (or partially satisfied) performance obligations to be expensed as incurred. In addition, the revenue standard requires fulfillment costs to be evaluated for expense or deferral independently of the recording of the associated revenue.

13.3.3.1 Recognition of Fulfillment Costs Incurred Before the Transfer of Goods or Services When Revenue Is Recognized Over Time

ASC 340-40-25-5 requires an entity to capitalize the costs incurred to fulfill a contract with a customer if the costs meet all of the following criteria:

The costs relate directly to a contract or to an anticipated contract that the entity can specifically identify . . . .
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.
The costs are expected to be recovered. [Emphasis added]

ASC 340-40-25-7 provides various examples of contract fulfillment costs, including direct labor, direct materials, and allocations of costs that are directly related to the contract (e.g., insurance, depreciation of tools and equipment used). In some contracts, fulfillment costs (e.g., implementation or other set-up costs) may be incurred before an entity begins satisfying its performance obligation. Further, in some cases, the costs incurred will enhance a resource of the entity that the entity will use in satisfying its performance obligation(s) to the customer.

An entity may need to exercise significant professional judgment when determining whether fulfillment costs incurred enhance a resource of the entity that the entity will use in satisfying its performance obligation(s) to the customer. To evaluate whether fulfillment costs meet the criterion in ASC 340-40-25-5(b) for capitalization, an entity should consider whether the costs (1) generate or enhance a resource (i.e., an asset, including a service) that will be transferred to the customer or (2) will be used by the entity in connection with transferring goods or services to the customer. The following considerations may be helpful in the evaluation:

Is the customer’s ability to benefit from the fulfillment activities limited to the use of the entity’s service? If the customer cannot benefit from the entity’s fulfillment activities other than from the use of the entity’s service, the fulfillment costs may be enhancing the entity’s resources.
Do the fulfillment activities expand the entity’s service capabilities? If the fulfillment activities are required before the entity can begin transferring services to the customer and they expand the entity’s service capacity, the related fulfillment costs would most likely enhance a resource of the entity that the entity will use in satisfying its performance obligation(s) to the customer.

We do not believe that an entity needs to have physical custody of an enhanced resource for fulfillment costs to qualify for capitalization under ASC 340-40-25-5(b). For example, the criterion in ASC 340-40-25-5(b) could be met if the enhancements are made at the customer’s location but will be used by the entity in connection with satisfying the performance obligation(s).

If the costs generate or enhance a resource that will be transferred to the customer, they may not enhance a resource of the entity that the entity will use in satisfying its performance obligation(s) to the customer. Such costs may still initially meet the criteria for capitalization (under either ASC 340-40 or other U.S. GAAP), but such costs would typically be recognized as an expense once the related asset is transferred to the customer.

Example 13-11

Entity P enters into a four-year contract with a customer to provide hosted software services. Before the hosted software services can begin, P is required to perform implementation services, which create interfaces between the customer’s infrastructure and P’s hosted software. The implementation services will not transfer to the customer a good or service that is distinct because the customer can only benefit from the interface connection through use of the hosted software services. For the implementation services, P charges the customer $600, which is included in the overall transaction price that is allocated to the performance obligation to provide hosted software services. Entity P incurs fulfillment costs of $500 to perform the implementation services.

Because the implementation services do not transfer a distinct good or service to the customer, the fulfillment costs of $500 do not enhance a resource that will be controlled by the customer. Rather, the fulfillment costs enhance a resource that P will use to satisfy its performance obligation. Therefore, the fulfillment costs of $500 meet the criterion in ASC 340-40-25-5(b) for capitalization.

13.3.3.2 Fulfillment Costs Related to Past Performance When Revenue Is Recognized Over Time

The example below illustrates the accounting for costs related to performance completed to date that an entity incurred to fulfill a contract satisfied over time.

Example 13-12

Entity X has entered into a contract that consists of a single performance obligation satisfied over time. The transaction price is $1,250, and the expected costs of fulfilling the contract are $1,000, resulting in an expected overall margin of 20 percent. Entity X has decided that it is appropriate to use an output method to measure its progress toward completion of the performance obligation.

As of the reporting date, X has incurred cumulative fulfillment costs of $360, all of which are related to performance completed to date. Using the output measure of progress, X determines that revenue with respect to performance completed to date should be measured at $405, resulting in a margin of approximately 11.1 percent for the work performed to date. The total expected costs of fulfilling the contract remain at $1,000.

ASC 340-40-25-8 lists certain costs incurred in fulfillment of the contract that must be expensed when incurred. As indicated in ASC 340-40-25-8(c), such costs include “[c]osts that relate to satisfied performance obligations (or partially satisfied performance obligations) in the contract (that is, costs that relate to past performance).” Accordingly, the $360 in cumulative fulfillment costs incurred should be expensed since all of these costs are related to performance completed to date.

As noted in ASC 606-10-25-31, the measure of progress used to recognize revenue for performance obligations satisfied over time is intended to depict the goods or services for which control has already been transferred to the customer. Recording an asset (e.g., work in progress) for costs of past performance would be inconsistent with the notion that control of the goods or services is transferred to the customer over time (i.e., as performance occurs).

However, any contract fulfillment costs incurred by an entity that are related to future performance (e.g., inventories and other assets that have not yet been used in the contract and are still controlled by the seller) would be recognized as assets if (1) they meet the conditions of a Codification topic or subtopic other than ASC 340-40 (e.g., ASC 330, ASC 350, ASC 360) or (2) they are outside the scope of a Codification topic or subtopic other than ASC 340-40 and meet all of the criteria in ASC 340-40-25-5.

In addition, note that if X had decided that it was appropriate to use cost as a measure of progress, X would have determined that the performance obligation is 36 percent complete, or ($360 ÷ $1,000) × 100%. Accordingly, X would have recognized revenue of $450 (36% × $1,250), which would have resulted in a margin of 20 percent.

13.3.3.3 Accounting for Costs Incurred in the Production of a Customized Good

Sometimes, an entity may incur costs at or near contract inception but before it begins to satisfy its performance obligations under the contract. This situation can arise when an entity purchases raw materials that will be used in the production of a customized good, as illustrated in the example below.

Example 13-13

Company KB produces aluminum-related products (“widgets”), which are created through a process of melting, molding, and curing the aluminum into a unique customized widget. The cost of the raw materials (i.e., aluminum) is significant to the overall cost of a widget (approximately 40–60 percent of the overall cost of the finished good). To produce a widget, KB must perform the following activities:

Procure the aluminum (i.e., the raw materials).
Melt the aluminum.
Mold the aluminum.
Polish the molded aluminum (i.e., polish the widget).

The raw materials (i.e., aluminum) purchased by KB are standard and not unique to a specific customer (i.e., KB can use the raw materials to fulfill any customer order). The molding’s design is based on a customer’s specifications (i.e., the mold used to create the widget is unique to a specific customer). Because the raw materials are not unique to a specific customer, KB could redirect the raw materials (and the melted aluminum) to a different customer before pouring the melted aluminum into the molding. However, once KB pours the melted aluminum into the mold, KB would incur significant costs to rework the molded aluminum for another customer. Therefore, the aluminum has no alternative use to KB other than to fulfill the initial order placed by a specific customer.

In addition, the termination clauses in KB’s contracts provide KB with an enforceable right to payment for performance completed to date if the contract is canceled. Accordingly, KB concludes that its performance obligation to produce a customized widget meets the criterion in ASC 606-10-25-27(c) to be satisfied over time because the completed widget has no alternative use and KB has an enforceable right to payment for performance completed to date. Company KB determines that the most appropriate measure of progress for recognizing revenue over time is labor hours incurred (that conclusion is not the subject of this example).

On March 26, 20X8, KB enters into a contract with a customer to produce a customized widget for a fixed price of $120. In a manner consistent with its general revenue recognition policy, KB recognizes revenue related to its contract over time by using labor hours incurred as the measure of progress.

Company KB expects that it will incur the following labor hours to produce the customized widget:

As noted above, before KB pours the melted aluminum into the molding, the aluminum has an alternative use to KB (i.e., KB can redirect the aluminum to another customer regardless of whether the aluminum is solid or liquid). Accordingly, until the aluminum is poured into the customer-specific molding, KB recognizes the aluminum in its raw material inventory. It is only when the melted aluminum is poured into the molding that KB will begin to perform under its contract with the customer because this is the point in time at which the aluminum has no alternative use to KB (i.e., because KB would incur significant costs to rework the molded aluminum for another customer). Therefore, KB should begin to recognize revenue once it pours the melted aluminum into the molding. On the basis of labor hours incurred, KB concludes that satisfaction of its performance obligation will be 2 percent complete once it begins to perform under the contract (i.e., when it begins pouring the melted aluminum into the molding). Consequently, KB will recognize revenue of $2.40 (2 percent of the fixed price per widget of $120) once the aluminum is melted and KB begins to pour the aluminum into the molding.

As also noted above, the cost of the raw materials (i.e., aluminum) is significant to the overall cost of the widget. In this arrangement, KB pays $50 for the aluminum materials. Company KB expects that its total cost of fulfilling the contract (inclusive of the $50 raw material cost) will be $100. That is, the raw material cost represents 50 percent of the estimated total costs that KB will incur under the contract.

Company KB should expense the cost of the aluminum once the melted aluminum is poured into the molding because this is the point in time at which the aluminum no longer has an alternative use to KB, which indicates that KB has commenced its performance under the contract (i.e., satisfaction of its performance obligation is 2 percent complete). Accordingly, the cost of the aluminum, which represents a fulfillment cost under the contract, should be expensed. This conclusion is consistent with the guidance in ASC 340-40-25-8(c), which requires costs related to satisfied or partially satisfied performance obligations to be expensed as incurred. In accordance with ASC 340-40-25-8(c), because KB will begin to satisfy its performance obligation under the contract when the melted aluminum is poured into the molding, the cost of the aluminum should be expensed once the aluminum is no longer deemed to be raw material inventory.

In addition to being consistent with the guidance in ASC 340-40-25-8(c), the conclusion in the example above that the cost of the aluminum should be expensed once the aluminum no longer has an alternative use to the entity is consistent with the following view expressed by the FASB staff in Implementation Q&A 76 (compiled from previously issued TRG Agenda Papers 33 and 34) regarding an analogous fact pattern:

The staff’s view is that costs incurred before the [contract establishment date (CED)] are costs to fulfill an anticipated contract and would be recognized as an asset under the guidance in Subtopic 340-40. Costs would be expensed immediately at the CED if they relate to progress made to date because the goods or services constituting a performance obligation have already been transferred to the customer. The remaining asset would be amortized over the period over which the goods or services to which the asset relates will be transferred to the customer.

13.3.3.4 Costs Incurred to Fulfill a Combined Performance Obligation Satisfied Over Time

ASC 340-40-25-5 through 25-8 provide guidance on accounting for costs incurred to fulfill a contract with a customer within the scope of ASC 606. Specifically, ASC 340-40-25-5 requires the following three criteria to be met for an entity to capitalize costs incurred to fulfill such a contract:

The costs relate directly to a contract or to an anticipated contract that the entity can specifically identify . . . .
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.
The costs are expected to be recovered.

In addition, ASC 340-40-25-8 requires an entity to recognize the following costs as expenses when incurred:

General and administrative costs (unless those costs are explicitly chargeable to the customer under the contract, in which case an entity shall evaluate those costs in accordance with paragraph 340-40-25-7)
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).

As quoted above, ASC 340-40-25-8(c) indicates that an entity should not capitalize costs related to completely or partially satisfied performance obligations. Further, ASC 340-40-25-8(d) requires an entity to expense costs when incurred if the entity cannot determine whether the costs are related to past performance or to future performance. Accordingly, if an entity incurs costs related to past performance or cannot determine whether the costs are related to past performance or to future performance, the entity should expense the costs when incurred rather than capitalize them.

In some arrangements, costs (other than set-up costs) are incurred at or around the time an entity begins to satisfy a performance obligation. For example, an entity may physically deliver hardware used as part of a combined performance obligation to provide services (e.g., an integrated monitoring solution) to a customer over time. That is, the hardware is not distinct; rather, it forms part of a combined performance obligation that is satisfied over time. The hardware may be recorded by the entity as inventory before it is physically transferred to the customer and would typically be derecognized by the entity once it is physically delivered to the customer since it would most likely be a fulfillment cost.

Depending on the facts and circumstances, it may or may not be acceptable under ASC 340-40 for an entity to capitalize initial fulfillment costs incurred when the costs are related to part of a combined performance obligation that will be satisfied over time. Generally, before delivery, the asset to which the fulfillment costs are related (e.g., hardware) is held in the entity’s inventory and is therefore within the scope of the inventory accounting guidance of ASC 330. However, once the asset is physically transferred to the customer, the asset may no longer be within the scope of ASC 330.

We observe that when the guidance in ASC 330 is applicable, ASC 330-10-10-1 and ASC 330-10-35-2 are particularly relevant to the determination of when to recognize the cost (i.e., expense) of the asset. ASC 330-10-10-1 states:

A major objective of accounting for inventories is the proper determination of income through the process of matching appropriate costs against revenues.

ASC 330-10-35-2 states, in part:

The cost basis of recording inventory ordinarily achieves the objective of a proper matching of costs and revenues.

Because the cost should be recognized with the related revenue, we believe that it may sometimes be acceptable to defer the cost.

In addition, we believe that in some cases, the asset may no longer be within the scope of ASC 330 once it is deployed in a specific customer contract (i.e., once it is shipped to a customer). At this point, the costs related to the asset could be evaluated as contract fulfillment costs in accordance with ASC 340-40.

If ASC 340-40 is applicable, an entity should consider the three criteria in ASC 340-40-25-5 to determine whether capitalization of the costs is appropriate. Generally, the asset to which the costs are related is physically delivered to the customer as part of a specific contract with that customer; therefore, criterion (a) is met. Further, if the entity expects to recover the costs of the delivered asset through the transaction price, the entity would conclude that criterion (c) is met.

Unlike the evaluations of criteria (a) and (c), respectively, which are relatively straightforward, the evaluation of whether criterion (b) is met (i.e., whether the costs generate or enhance a resource of the entity that the entity will use to satisfy its performance obligation in the future) generally requires more judgment. As discussed in Section 13.3.3.1, an entity should consider the following factors to determine whether the asset delivered to the customer generates or enhances a resource of the entity that the entity will use to satisfy its performance obligation in the future (e.g., to provide the ongoing service):

Is the customer’s ability to benefit from the fulfillment activities limited to the use of the entity’s service? If the customer cannot benefit from the entity’s fulfillment activities other than from the use of the entity’s service, the fulfillment costs may be enhancing the entity’s resources.
Do the fulfillment activities expand the entity’s service capabilities? If the fulfillment activities are required before the entity can begin transferring services to the customer and they expand the entity’s service capacity, the related fulfillment costs would most likely enhance a resource of the entity that the entity will use in satisfying its performance obligation(s) to the customer.

We also believe that the following additional factors are relevant to the determination of whether capitalization of the fulfillment costs is appropriate:

Does the activity that results in delivery of the asset to the customer factor into the entity’s measure of progress toward complete satisfaction of the performance obligation? For example, the entity may demonstrate that the fulfillment costs enhance a resource that will be used to satisfy the entity’s performance obligation in the future if the entity does not begin satisfying its performance obligation until the asset is delivered to the customer.
Does the entity still have some level of control or influence over the asset once the asset is physically delivered to the customer? Although the asset is physically delivered to the customer, the entity may be providing a service that requires the entity to integrate the asset and the service to deliver a combined output (e.g., because the asset and service are highly interdependent or highly interrelated). The entity may conclude that by transferring a combined service to the customer (e.g., a service that the entity delivers by using both hardware and the service), it continues to maintain some level of control or influence over the asset that is being used as an input to deliver a combined output. That is, the entity’s service continues to dictate how the customer uses the asset even if the customer has physical possession. This analysis is consistent with the evaluation of whether an entity controls a good or service before the good or service is transferred to an end customer and therefore is a principal, as discussed in ASC 606-10-55-37A(c).

On the basis of the above factors, an entity should evaluate whether the fulfillment costs enhance the entity’s resources that the entity will use to satisfy (or continue to satisfy) its performance obligation in the future. If the entity determines that capitalization of the related costs is appropriate in accordance with ASC 340-40-25-5, it should subsequently amortize the costs related to the asset as it transfers the related services.

Because of the level of judgment necessary to evaluate whether capitalization is appropriate — specifically, whether the asset generates or enhances a resource of the entity that the entity will use to satisfy its remaining performance obligation — we would encourage entities with similar types of arrangements to consult with their accounting advisers. Further, it may be appropriate in some cases to evaluate whether the arrangement contains a lease when the performance of the contract relies on a specified asset; see Deloitte’s Roadmap Leases for more information on determining whether a contract is or contains a lease.

13.3.3.5 Learning Curve Costs

Certain contracts may include significant costs associated with a “learning curve.” In these instances, because the entity has not yet gained process and knowledge efficiencies, significant costs attributed to a learning curve may be incurred during the early phases of the contract.

We believe that learning curve costs are generally not eligible for capitalization under ASC 340-40. This view is consistent with paragraphs BC312 through BC314 of ASU 2014-09, in which the FASB states, in part, that ASC 606 addresses the accounting for the effects of learning costs when both of the following conditions are met:

“An entity has a single performance obligation to deliver a specified number of units.”
“The performance obligation is satisfied over time.”

The FASB states that in this situation, an entity would most likely select the cost-to-cost method to measure the progress of transferring the goods or services to the customer since under this method, the entity would record more revenue and expense for the units produced early in the production cycle (as a result of the learning curve costs) than it would for the later units. The Board explains that this method of measurement is appropriate because if an entity were to sell a customer only one unit rather than multiple units, the entity would charge the customer a higher per-unit price to recover its learning curve costs. Since the performance obligation is satisfied over time (because control is transferred to the customer as the costs are incurred), capitalization of learning curve costs would not be appropriate in this situation because the costs are related to the fulfillment of a partially satisfied performance obligation.

13.3.3.6 Labor Costs Incurred to Fulfill a Contract for Goods or Services When Revenue Is Recognized Over Time

ASC 340-40-25-7 provides guidance on the types of costs that constitute fulfillment costs within the scope of ASC 340-40 if they are outside the scope of other Codification topics. Costs incurred to produce goods for which revenue is recognized at a point in time would typically be treated as inventory costs within the scope of ASC 330. However, costs incurred to provide goods or services for which revenue is recognized over time would typically not be within the scope of ASC 330 since control over those goods or services is transferred to the customer as the entity performs.

Questions have arisen regarding the amounts to be included in fulfillment costs related to labor.

While “salaries and wages of employees who provide the promised services directly to the customer” are the only example of direct labor costs that is cited in ASC 340-40-25-7(a), direct labor costs also include fringe benefits and other labor-related costs incurred in compensating an employee whose primary employment efforts are directly related to a contract with a customer. In addition, ASC 340-40-25-7(c) indicates that fulfillment costs include certain allocated labor costs (i.e., indirect labor costs) related to overhead, such as those incurred for contract management and supervision.

We believe that costs that would have been capitalizable as inventory had they been within the scope of ASC 330 would typically also represent fulfillment costs directly related to a contract in accordance with ASC 340-40. ASC 330-10-30-1 provides the following guidance on determining the amounts to be included in inventory:

As applied to inventories, cost means in principle the sum of the applicable expenditures and charges directly or indirectly incurred in bringing an article to its existing condition and location. It is understood to mean acquisition and production cost, and its determination involves many considerations.

In authoritative literature, specific references to the composition of labor costs are limited. However, the ASC master glossary’s definition of direct loan origination costs includes a reference to ASC 310-20-55, which includes examples of forms of employee compensation that would be considered direct labor costs associated with originating a loan. Although the concepts discussed in the examples are specifically related to direct costs incurred in connection with loan origination activities, we believe that it is appropriate for an entity to consider the implementation guidance in ASC 310-20 by analogy to identify forms of employee compensation that should be included in the composition of labor costs.

The example in ASC 310-20-55-12 states:

Payroll-related fringe benefits include any costs incurred for employees as part of the total compensation and benefits program. Examples of such benefits include all of the following:

Payroll taxes
Dental and medical insurance
Group life insurance
Retirement plans
401(k) plans
Stock compensation plans, such as stock options and stock appreciation rights
Overtime meal allowances.

Further, ASC 310-20-25-6 states, in part:

Bonuses are part of an employee’s total compensation. The portion of the employee’s total compensation that may be deferred as direct loan origination costs is the portion that is directly related to time spent on the activities contemplated in the definition of that term and results in the origination of a loan.

We believe that in a manner consistent with the above guidance, labor costs include base pay, overtime pay, vacation and holiday pay, illness pay, shift differential, payroll taxes, and contributions to a supplemental unemployment benefit plan. Further, other employee benefit costs such as cash bonuses, profit sharing, stock bonus plans, insurance benefits, retirement benefits, and other miscellaneous benefits (both discretionary and nondiscretionary) are among the labor costs that are eligible for inclusion in fulfillment costs directly related to a contract.

13.3.4 Costs Related to Preproduction Activities

Preproduction costs of a long-term supply arrangement represent incurred costs related to the design and development of products to be sold under an entity’s contract with a customer, which could be an anticipated contract that the entity can specifically identify. For example, preproduction costs could include dies and other tools (tooling) that the entity will use in making products under the arrangement. The dies and other tools may or may not be transferred to the customer under such an arrangement.

The TRG addressed certain issues related to the costs that an entity incurs in performing these preproduction activities. Stakeholders raised questions about how an entity should apply the revenue standard’s cost guidance when assessing preproduction activities, including questions related to the scope of the guidance (i.e., the costs to which such guidance would apply). Specifically, TRG members in the United States discussed whether entities should continue to account for certain preproduction costs under ASC 340-10 or whether such costs will be within the scope of ASC 340-40 after the revenue standard becomes effective.

The FASB considered removing the guidance in ASC 340-10 to confirm that these costs would be within the scope of ASC 340-40. However, in February 2017, the FASB ultimately elected to retain the guidance in ASC 340-10 on accounting for preproduction costs related to long-term supply arrangements. Accordingly, the costs previously within the scope of ASC 340-10 will continue to be within the scope of ASC 340-10.

The above issue is addressed in Implementation Q&A 66 (compiled from previously issued TRG Agenda Papers 46 and 49). For additional information and Deloitte’s summary of issues discussed in the Implementation Q&As, see Appendix C.

While retaining the guidance in ASC 340-10 will clarify how to account for costs that are squarely within the scope of that guidance, there remain questions related to the accounting for fulfillment costs that are not clearly within the scope of ASC 340-10 (or other applicable U.S. GAAP) and to which the guidance in ASC 340-40 may be applicable. For example, when an entity begins incurring costs that enhance a resource that may be used to satisfy an obligation with a potential customer (i.e., there is not yet a contract with a customer), or when an entity receives consideration from a potential customer to fully or partially cover the costs incurred, the entity may need to use significant judgment in determining whether the fulfillment costs incurred are within the scope of ASC 340-40. We believe that entities may find the following considerations helpful when evaluating the accounting for preproduction costs:

Are the fulfillment costs related to a contract with a customer that can be specifically identified? If so, the costs are likely to be within the scope of ASC 340-40 (if they are not within the scope of other guidance).
Do the fulfillment costs create a good or service that will be transferred to a customer? If so, the costs are likely to be deferred until the good or service is transferred to the customer.
Do the fulfillment costs create an output that is part of the entity’s ordinary activities? If the costs incurred create an asset that will be transferred to a third party, but the asset to be transferred is not an output of the entity’s ordinary activities, the counterparty is not a customer as defined in ASC 606, and therefore, the arrangement is not within the scope of ASC 606 or ASC 340-40.

Entities may receive payments from customers, potential customers, or third parties that are intended to cover some or all of the costs of certain preproduction activities. An entity’s conclusion regarding the scope of the associated costs may inform the entity’s accounting for the corresponding payment. For example, if an entity concludes that it is incurring preproduction costs that are within the scope of ASC 340-40 but are not related to a good or service that will be transferred to the customer (i.e., the costs are not performance obligations), any consideration that the entity received from the customer would be within the scope of ASC 606 and would form part of the transaction price in the contract with the customer. However, if an entity concludes that the fulfillment costs incurred are not within the scope of ASC 340-40 (e.g., because they are not related to a contract or anticipated contract that the entity can specifically identify), third-party reimbursements of such costs may not be within the scope of ASC 606.

13.3.5 Set-Up and Mobilization Costs

Set-up and mobilization costs represent certain direct costs incurred at contract inception to allow an entity to satisfy its performance obligations. For example, when construction companies prepare to begin performance under a contract with a customer, they often incur direct costs related to the transportation (i.e., “mobilization”) of equipment (e.g., cranes, cement trucks) that they would not have incurred if the contract had not been obtained. In other industries, mobilization may include activities such as system preparation, staff training, or the hiring of additional staff.

When an entity’s contract involves mobilization activities, it is important for the entity to consider whether those activities (1) transfer control of one or more promised goods or services to a customer as they are performed or (2) are set-up activities for the entity’s benefit that facilitate the transfer of one or more promised goods or services to a customer in the future.

When mobilization activities transfer benefit to an entity’s customer as they are performed, the entity will need to consider whether those activities (1) represent one or more distinct goods or services or (2) form part of a larger performance obligation.

Frequently, costs related to the mobilization of equipment do not result in the transfer of a good or service to the customer; rather, they represent set-up activities. The costs incurred in the mobilization of machinery (e.g., labor, overhead, other direct costs) may meet the definition of assets under other U.S. GAAP, such as the guidance on property, plant, and equipment. To the extent that costs are not within the scope of other accounting standards and do not result in the transfer of a good or service to the customer, entities should assess these costs in accordance with the revenue standard’s cost guidance in ASC 340-40.

If an entity has acquired new equipment to be used in the fulfillment of a contract, certain costs that the entity incurred in transporting the new equipment to a designated location must be capitalized as an asset under ASC 360. In contrast, once equipment has been used and is then transported for use under a separate contract, such costs would no longer be within the scope of ASC 360. However, the costs may be viewed as fulfillment costs. If the entity concludes that the costs are fulfillment costs outside the scope of ASC 360, it should apply the guidance in ASC 340-40 to determine whether capitalization is appropriate.

The example below illustrates the accounting for set-up and mobilization costs.

Example 13-14

Company A enters into a contract with a customer to construct an urban skyscraper over a two-year period. To fulfill the contract, A determines that it will need to purchase two new cranes. Company A incurs $150,000 to have these cranes transported to a facility where A stores cranes that are not currently deployed. The company also incurs $500,000 in direct costs to transport the two new cranes and five additional cranes from the storage area to the designated customer location. Company A determines that the transportation costs are expected to be recovered through the contract with the customer. In addition, A concludes that the use of the cranes to construct the skyscraper does not constitute a lease under ASC 842.

Because the $150,000 represents costs incurred to get new equipment ready for its intended use (i.e., transportation of newly acquired equipment), A should apply the guidance in ASC 360 to account for such costs.

Regarding the $500,000 in direct costs to transport the cranes to the customer’s location: ASC 340-40-25-5 requires an entity to recognize an asset for costs incurred in the fulfillment of a contract if the costs (1) are directly related to the contract, (2) enhance the resources that the entity will use to perform under the contract, and (3) are expected to be recovered. Company A should recognize the transportation costs of $500,000 as an asset when incurred because (1) the cranes (and therefore the related transportation costs) are directly related to the contract, (2) relocating the cranes enhances the entity’s resources (i.e., the cranes) since it puts the cranes in a location that allows the entity to satisfy its performance obligation(s) under the contract, and (3) A has determined that the transportation costs are expected to be recovered.

13.3.6 Relationship Between ASC 985-20 and ASC 340-40

ASC 985-20-15-3 states, in part, that the guidance in ASC 985-20 does not apply to “[a]rrangements to deliver software or a software system, either alone or together with other products or services, requiring significant production, modification, or customization of software.” ASC 985-20 generally applies to the costs of computer software that is being developed for general release to the market as opposed to being developed solely to meet a specific customer’s needs. Nevertheless, some costs may be incurred for software that (1) will be delivered to a specific customer under a contract and (2) also will be marketed to others. As illustrated in the example below, the vendor should determine which costs are incurred for software that is being developed for general release and which costs are incurred for software that is being developed for specific contracts.

A vendor may be required to apply the guidance in ASC 985-20 when accounting for software costs it incurred before entering into a contract if the costs were incurred for a product that will be marketed to multiple customers. However, a vendor must use judgment to determine whether costs incurred to develop software before a contract is signed are costs associated with fulfilling the contract and therefore subject to the guidance in ASC 340-40 or costs subject to the requirements of ASC 985-20, particularly when there is a very limited market for the product and the product will require additional customization under contracts with future customers.

Example 13-15

Entity L has existing software that it has used on a previous contract for which it maintains the proprietary rights. It had begun to reconfigure the software into an open architecture format when it signed a contract for delivery of a strategic air defense system that will use at least some of the modules of the open architecture software. Entity L anticipates that it will be able to use the open architecture software on several future contracts.

Under ASC 985-20, L may be required to capitalize some of the software development costs associated with the reconfigured open architecture software if those costs meet the criteria for capitalization. However, the costs associated with developing the modules in accordance with the terms of the defense contract should not be accounted for under ASC 985-20 if significant production, modification, or customization of the software would be required; instead, such costs should be accounted for under ASC 340-40.

As noted above, ASC 985-20 does not apply to costs incurred for computer software that requires significant production, modification, or customization under a contractual agreement. Although L retains the rights to the software, at least some portion of the development effort must be used to satisfy the requirements of the defense contract. The costs associated with developing modules that are promised goods or services under that contract are costs incurred to fulfill the contract and thus within the scope of ASC 340-40; accordingly, they should not be accounted for under ASC 985-20.

If the ultimate product will include functionalities that are distinct and separable and are not promised goods or services under the current defense contract (i.e., they will be used only for future contracts), the development costs of such functionalities might be subject to the guidance in ASC 985-20 depending on the market for the software. That is, if the additional modules have a broad customer base and are not limited to one or a few contracts, ASC 985-20 would apply since the costs for these additional modules would be incurred in the absence of a specific contract.

Footnotes

ASC 340-40-25-6 indicates that when costs incurred to fulfill a contract with a customer are within the scope of any other Codification topics or subtopics, such costs should be accounted for in accordance with those other topics or subtopics.

The entity may need to consider applying the impairment guidance in ASC 330 to similar goods held in inventory.

Confidential and Proprietary — for Use Solely by Authorized Personnel

This publication provides comprehensive guidance; however, it does not address all possible fact patterns, and the guidance is subject to change. Consult a Deloitte & Touche LLP professional regarding your specific issues and questions.