Contract Costs: Acquisition & Fulfillment | CPA FAR (ASC 340-40)

Hello and welcome to this section. This is professor Farad in which we will discuss accounting for cost associated with customer contract. To obtain a new contract, often times we have to incur some sort of a cost. Maybe legal cost, maybe marketing cost, some cost to convince the customer that we are the right solution for them. So businesses incur these cost before a customer contract is signed. So basically there's a place where you sign a contract a time not a place a place and a time but there's a time before you sign this contract that you incur certain cost and after you obtain that contract there are costs that incur while performing the contract and these costs are not are not all accounted for the same way. Why? Because if you know anything about cost, every time we incur a cost, a company will have to make a decision whether that cost is an asset which is mean capitalized or an expense. So specifically in this session, we have to determine the cost that's contract related. Contract related mean the cost that we incur to obtain to sign this c to sign this new customer. How are we going to treat this cost? Well, some costs are expensed immediately. Other costs are recorded as an asset because they are expensed to provide future benefits. Simply put, we capitalize them. Now, to be more specific, we will break down the contract related cost into two categories. Cost incurred to obtain the contract. So, remember we signed the contract cost before and cost to fulfill that contract which is after. And this is what we will discuss. will determine what cost is incurred before, how do we treat them, what cost is incurred to fulfill the contract and how do we treat them. This is what we will discuss in this session. Let's go ahead and start to discuss cost incurred to obtain a contract. Before we proceed any further, I have a public announcement about my company for farlectures.com. My AI turns any lecture into a complete study system. You can create summary table, formulas and example from each lecture. Flashcard builds from the lesson itself. A quiz build on the lesson and as a bonus convert any lecture into a portable short audio on the go. So it helps you with the retention. No noise, no generic responses, just clarity based on that specific lecture. Don't just watch, interact, test yourself and retain the material using Farhat AI. Now go to forhat lectures.com now and see how the AI can help you understand, practice and retain the material. What is a cost incurred to obtain a contract? Well, think of a lawyer. You might have to hire a lawyer. You might have you might have a legal team inside the company or you may not. So let's assume you hire the lawyer for this contract work to draft the contract for you. Well, that's an incremental cost. Incremental means what? Incremental means that's an additional cost that the company would not have incurred unless it it successfully obtained the contract. So when do you draft a contract? You draft a contract when you the other party is ready to sign. So you have to ask yourself would this cost exist without signing the contract? Well if the cost does does not exist then it's if it does exist you have to ask yourself would this cost exist without signing the contract. If it exists regardless then it's not a cost to obtain the contract. But if this cost exist because you are signing the contract because you are signing the contract it's incremental cost. If you need to hire this lawyer to draft the legal agreement you incur this cost because you signed the contract. So if the customer signed and you are incurring the cost that's an incremental cost. If this cost is going to happen anyway it's a sunk cost. Let's assume, just to simplify it, a lawyer versus, let's assume you had to travel to Vegas, to Las Vegas to meet a customer. Well, guess what? You're going to have to travel to Vegas to to Vegas to meet that customer. Whether that customer signed the contract or did not sign the contract, you have to incur this travel cost. It's regardless. But once you're in Vegas, you guys negotiated and you agree to proceed, you might contact the lawyer and ask them to draft a contract. This is in incremental cost. So we need to know what is the incremental cost. Also we need to know the difference between capitalization versus expensing which is we started by talking about this on the prior slide. But let's dive a little bit deeper into the general concept of capitalization versus expensing. It's an important concept. As an accounting student, CPA, CMA, you have to be very familiar with what is capitalization, what's expensing. So capitalization is when we treat the expenditure as an asset. So what are the capitalization rule? If we incur an incremental cost of obtaining a contract is recorded that cost is recorded as a as an asset when the cost would not have been incurred without obtaining the contract. So this cost specifically was incurred because we obtained the contract. The company expect to recover this cost through the contract. So yes, we incur the cost but don't worry we kind of build the expenditure in the revenue because obviously if you incur a cost as a business you want to recover this and the capitalized amount is later amvertised as the company transferred the related goods or service to the to the customer and what you have to do with that cost you will have to expense it through amortization and what's amortization taking the capitalized cost and expensing that capitalized cost. So this is the rules the general rule for capitalization. Expensing well a cost is generally expense when the company would have incurred it regardless of whether the contract is signed or not. You had to travel to Vegas to Las Vegas to negotiate with the other party. You don't know whether the contract will be signed or not. You had to travel. So employee salaries for preparing proposal. If you're if you're paying your employees to prepare the proposal, the contract may or may not may not be signed. Nevertheless, you have to pay the employee. Travel costs incurred during sales presentation, advertising cost, bid preparation cost, general marketing cost, legal review fees even if negotiation fails. If you are asking someone to review certain document, this is not not because the contract is signed. Maybe they made a proposal and you are legally reviewing the the contract. Nothing happened yet. No contract is signed. Well, that's different. That's expense. The fact that a cost helped the company obtain a contract doesn't automatically make it an asset. The cost must be directly dependent on the successful completion of the contract. So, we incur this cost because because we had to sign this contract. So ask yourself, would the company have incurred this cost if the customer had not signed this contract? If the answer is no, the cost may qualify for capitalization because we only incurred it because [snorts] we signed the contract. If the answer is yes, so we would have this cost regardless, then it's an expense. Now, the best way to illustrate this is to look at an example cost of obtaining a contract. Let's assume a security services company negotiated a 4-year agreement to provide monitoring services to a hospital network and the company incurred the following cost during the negotiation. Salaries to employee who prepared the proposal 14,000 travel and lodging for the sales presentation 5,000 commission payable after the agreement is signed 18,000 outside attorney fee payable if the contract closes 6,000. So let's determine how do we treat each of these cost salaries of employees. We pay the employees 14,000. They prepare the proposal. Look, if those are our employees, we are going to have to pay them salaries whether they are working on the proposal or working on something else. So they have nothing to do specifically incurred specifically for this contract. Therefore, the 14,000 is X P. Travel and lodging for sales presentation. Well, the company incurred these cost during the sales process. The cost would still have been incurred if the customer rejected the proposal. Even if the customer at the end says not interested in your proposal, I already incur these cost. So, signing or not signing has nothing to do with it. Therefore, I expense it. Commission payable only after the agreement is signed. Now you're paying someone maybe an outside party to negotiate on your behalf. But you only pay them if the negotiation is successful. If the contract is signed, this is different. This is capitalized. We expect also to recover this. We we paid someone 18,000. We're going to put this back into the contract somehow to recover outside attorney fee payable only if the contract closes. Only if the contract closes. means we're going to we're going to incur this fee only if this contract goes ahead. Therefore, this is capitalized and this is what you would expect to answer on the CPA exam questions like this. Now, we have to be aware of legal fees. We have to kind of clarify this. Legal fees are not automatically all capitalized. We have to be careful. The correct treatment depending on the payment arrangement. So, what are you dealing with? a legal fee payable. Regardless of whether a contract is signed or not, it's expense. So, if you have a in-house lawyer and you're paying them salary, it doesn't matter whether the proposal is signed or not, it's an expense. A legal fee payable only when the contract is successfully obtained may qualify for capitalization. A legal fee associated with creating a separate legal asset or acquiring another identifiable asset may be governed by a different accounting standard depending on what the issue is. So legal fees is not automatically capitalized. Just know these two rules because sometime legal fees are associated with some third party like you buy a land there's a closing cost that's capitalized. So the CPA exam often require candidate to analyze the underlying fact rather than relying only on the name of the cost. Just because it's a legal expense, it doesn't mean it's automatically capitalized or expensed. Read the question carefully and ask yourself, would this legal cost be incurred regardless? It's an expense. If it's only in being incurred because the contract is signed, it's an incremental cost to obtain the contract. Now let's move from the cost of obtaining the contract until the post signing. Now they sign, we're going to have a cost for fulfilling the contract. So after the contract is signed, the company will incur cost to prepare for or perform its its contractual obligation. Well, a fulfillment cost is recorded as an asset only when all three conditions exist. So there's three conditions for that. What are they? The cost related directly to the specific contract or an expected contract. So the cost that we are incurring ties directly with this contract. That's one. It's not the only one. They have to be all three together. The cost creates or improve a resource that will be used to satisfy future performance obligation. So that's the second condition. So the cost created the cost incurred creates or improve a resource. And we'll look at an example for each. And the third condition, the cost is expected to be recovered. That's always the case. Now remember all three conditions must be met. So before applying these criteria the company must determine whether another accounting standard apply. For example, cost involving inventory, equipment, intangible asset, software. Those are just to follow the rules of how do we capitalize inventory? How do we capitalize equipment? How do we capitalize intangible asset? What we're looking at is cost for fulfilling the contract. And as long as they meet those three criterias, we will capitalize them. Now let's dive into each one of them. What do we mean by condition one? The cost relates directly to the contract. It means the cost must be clearly connected to the contract like direct labor, direct material, payment to subcontractor, contract specific design specific design work, allocated costs directly related to to contract performance cost explicitly chargeable to the customer. It means we are going to recover it. Now keep in mind general business costs usually do not qualify because they support the entity as a whole rather than a specific customer contract. So if the cost is for the entire company, it doesn't relate directly to the contract. So those has to relate directly to the to the contract. Condition two, the cost create or enhances a resource. Basically, you're creating an asset. The cost must create or improve something the company will use to provide future goods or service. It means it's creating an asset. So, a resource may include customized design, contract specific databases, um a production setup, a specialized template, work performed in advance of future services, material dedicated to future contract performance. So, whatever you are incurring, you can use it's it's creating or enhancing an asset. resource is an asset. And how do we know we have an asset? If something provide future goods or service, that's the definition of an asset. An asset is a resource that provide future benefit. So keep in mind the cost does not merely qualify because it's associated with a customer. It must also produce a benefit that support future performance. And the third condition is the cost is expected to be recovered because the assumption is you're capitalizing it then you're going to recover it. Recovery may occur through the contract price some reimbursement clause expected future revenue payments connected with future contract performance. Simply put, you expect to recover this cost one way or another. Now keep in mind you should not capitalize if there is any doubt about recovery. If you don't think you can rec recover this cost, then you don't do that. So you have to meet all three. All three. So that's why in the example they they will always tell you expected the cost expected to be recovered. So let's take a look at this example. A medical records company signed a three-year agreement to convert paper files into a secure electronic archive. Before processing began, the company incurred the following cost. Development of a customer specific indexing system 30,000. Purchasing of scanning equipment 45,000. Salary of an existing operation manager assigned part-time to the project. Cost of redoing work caused by employee mistakes. We're going to assume that all costs are expected to be recovered. So, condition three is already met. Okay. Let's start with the $30,000 which is the development of a customer specific indexing system. Now, is this related specifically to the contract? Yes. Let let me ask you this. Do you think if you if you can create a customer specific indexing system for this customer, do you think you can use this knowledge for another customer? I would say yes, you can. So, you are you are creating a resource that could be used in the future. So, it's related to a customer. The resource can be used in the future. And we are told the the amount can be recoverable means what does that mean? The 30,000 capitalized purchase of scanning equipment. Now let me tell you, you don't have to think about it. They're telling you equipment scanning equipment. We capitalize equipment. That's it. This has not to do with um just think about it from an asset perspective. Equipment fits the definition of an asset. Uh you could use this equipment in the future. It's an asset. You capitalize it. salary of an existing operation manager assigned part-time to the project. Now, we have a manager, an operation manager, and we're assigning this manager to the project, and we're paying we're paying the 12,000. Look, it's an existing operation manager. Whether we assign them or not, we still have to pay them. That's an expense. So, this is capitalized. Cost of redoing work caused by employee mistakes. Is this related to a particular customer? Yes. Would this create resources and future performance? Would errors cause a create any sort of a of a future benefit? Absolutely not. And most likely we may not be able to recover because we did not account for that. But here they're saying expected to be recovered. So it's going to meet condition three, but definitely it's not going to meet condition two. Most likely there's a good chance you cannot even recover it. If your c if your employee made the mistake, you might have to absorb it. But regardless, it's an expense. And this is a detailed solution analysis of these three three conditions. Abnormal waste. Abnormal any waste that's abnormal, not normal, it's charged to expense includes material destroyed because of improper handling. Excess labor caused by preventable error. Uh rework resulting from poor quality. We just talked about this. Idle time caused by avoidable delays. unusual spoilage. These costs do not create or improve a resource and therefore do not provide future benefit. Therefore, they don't meet condition two. Therefore, they are not capitalized. You might be able to recover them. You might be able to charge them to a customer, but they don't meet the second condition. For example, a manufacturer enters into a contract to produce custom conference tables. They produce furniture. The company purchased 80,000 of wood for the project. During production, 72,000 of the 80,000 is used normally. 8,000 of the wood is destroyed because of the employee stored it incorrectly. Guess what? The 72,000 will be included in inventory as part of the asset or some appropriate asset. Uh if it's maybe uh work in process, the 8,000 is expensed. So you have to know that any waste is expensed. We have to understand the simple rule. The cost cannot be recorded as an asset when it relates to a good or service that already been transferred to the customer. So once the goods or the service is transferred to the customer, if you incur additional cost, you cannot consider this as an asset. Once the associated performance obligation has been satisfied, the related benefit is gone, has been consumed by the customer. Therefore, there is no future benefit. For example, a consultant firms complete the first phase of the project. After the delivering the report, it incur 4,000 to revise formatting error in the completed project. The 4,000 is expensed because it relate to work that has been already performed. The cost does not support a future performance obligation. Now, keep in mind any cost that's capitalized contract cost will be amortized. A capitalized contract cost is not kept indefinitely on the balance sheet. The asset is advertised. As the related goods or services are transferred to customer. So eventually what do we do with this capitalized cost? We will expense it. So we're not expensing it now, but eventually we'll expense it. Just like any asset, what do we do with all assets? Eventually they get burned, expensed. They go to battle. They get used up. They are expensed, amortized, whatever you want to call it. The appreciated. The amortization pattern should reflect the timing of the expected benefit. So, you will try to expense it over the period that's benefiting. For example, a company capitalized $36,000 commission related to a three-year service agreement. Assume these services are provided evenly. What do you do? You spread the 36 over 3 years and you will advertise $12,000 per year. You will debit amortization expense, credit contract cost, or accumulated amortization. They're both good. Now you have to know if you created an asset and this asset would last a short period of time, you would just expense immediately. Short period means one year or less. And this election is for practical expediency. So you don't want to worry about something that's going to go away, an asset that's going to be burned, used up within one year. For example, a telecommunication provider pays $300 commission for a one-year service contract. The company would apply practical expediency. it may expense the commission immediately instead of putting it as an asset and uh taking care of it down the road. What should you do now? If you're a CPA exam candidate, accounting, whatever student you are, you're studying using this information, go to Farhad lectures, look at additional multiplechoice exercises, resource, true false AI resources that will help you succeed. Whether you are a student or studying for a professional certification, the best investment you can make is invest in yourself. Don't short change yourself. And God bless.