How to Account for Contract Costs
By Darlene Angelucci, Director, Assurance Services
In an attempt to obtain a contract with customers (such as patients, residents or members), healthcare entities incur incremental costs. Examples include advertising, marketing, commissions, salaries, incentive compensation, actuarial and legal expenses, etc. Once an incremental cost is incurred, the next step for the healthcare provider is determining how to account for it. Specifically, should the incremental costs be capitalized as an asset or should they be expensed as incurred?
In accordance with FASB ASC 340-40, Other Assets and Deferred Costs – Contracts with Customers, the incremental costs of securing a contract with a customer are recognized as an asset if the entity expects to recover them. The key factor in determining if the costs are recoverable is: will the incremental costs be recovered directly through reimbursement under the contract or will they be recovered indirectly through the margin inherent in the contract?
Careful consideration is needed to determine whether costs to obtain a contract are incremental. The FASB staff suggests that, to determine whether a cost is incremental, an entity should consider whether it would incur the cost if the customer decides that he/she will not enter into the contract. If the costs would have been incurred despite the contract not being executed, the costs are not incremental to securing the contract.
Determining if costs are incremental to the contract will require analysis of how the various contracts are obtained, which costs are directly associated with the contracts, and if those costs would have been incurred regardless of the outcome of securing the contract. The following are types of costs that may qualify to be capitalized as incremental costs: (1) sales commissions, (2) contingent legal fees, meaning fees that are payable only if there is a successful negotiation of a contract, and (3) other costs incurred only as a result of obtaining the contract. According to ASC 340-40, sales commissions that are directly related to sales achieved during a time period generally represent incremental costs that would require capitalization. Conversely, certain bonuses and other compensation that is based on profitability or performance evaluations usually do not meet the capitalization criteria, due to the fact that they are not directly related to obtaining a contract.
Further, ASC 340-40 provides a description of costs that should be expensed as incurred. Specifically, these include costs to obtain a contract that would have been incurred regardless of whether the contract was secured, unless those costs are explicitly chargeable to the customer. For example, general and administrative costs are expensed as incurred unless they are explicitly charged to the contract.
In addition to incremental costs, a healthcare service provider may enter into a contract that requires it to incur costs to fulfill such contract. ASC 340-40 divides contract fulfillment costs into two categories: (1) those that give rise to an asset, and (2) those that are expensed as incurred. The entity must first determine whether contract fulfillment costs are in the scope of other accounting guidance (e.g., ASC 330 on inventory, ASC 360 on fixed assets, and FASB 720-35 on advertising costs) prior to determining whether they must be capitalized or expensed under ASC 340-40. In order for a healthcare organization to capitalize the costs of fulfilling a contract that is not within the scope of existing FASB ASC cost guidance, all of the criteria in ASC 340-40 must be met, including the criteria that “the costs generate or enhance resources of the entity that will be used by the entity in satisfying or continuing to satisfy future performance obligations.”
Once it is determined that an asset will be recognized for either an incremental or fulfillment cost, such asset is required to be amortized on a systematic basis that is consistent with the transfer to the customer of goods or services to which the asset pertains. For a CCRC entrance fee contract, the amortization of the related capitalized contract acquisition costs should mirror the pattern of the transfer of goods and services. In situations where the contracts have multiple performance obligations, healthcare organizations should apply careful judgment when determining how to allocate the asset to the individual performance obligation, and amortize the portion of the asset based on the performance pattern for the underlying performance obligation. Finally, ASC 340-40 states that “an entity shall recognize an impairment loss to the extent that the carrying amount of the asset recognized for incremental costs of securing a contract with a customer or for fulfillment costs exceeds (a) the amount of consideration that the entity expects to receive in the future and that the entity has received, but has not recognized as revenue, in exchange for the goods or services to which the asset relates, less (b) the costs that directly relate to providing those goods or services and that have not been recognized as expenses.