Understanding GAAP – ASC 340-40
The Accounting Standards Codification (ASC) is essential in keeping the integrity and consistency of financial reporting in the United States. Besides ASC 606 compliance, the ASC 340-40 has set criteria for firms to capitalize on short-term contract acquisition expenses.
In this article, we’ll explain the definition, process, and considerations to navigate the ASC 340-40 standard successfully.
ASC 340-40 definition, purpose & components
According to Deloitte, this revenue standard defines incremental costs of obtaining a contract as “costs that an entity incurs to obtain a contract with a customer that it would not have incurred if the contract had not been obtained.”
What’s the context & need for ASC 340-40?
Companies often engage in various short-term contracts to secure new customers or projects. These contracts may require additional expenditures to secure, such as sales commissions or legal fees.
This standard has many benefits for businesses, as it simplifies accounting for short-term contract acquisition, ensures expenses are recognized more timely, and promotes consistency and comparability in financial reporting.
Before ASC 340-40, entities were required to capitalize and amortize these expenses over the contract's life, which could lead to complexities in financial reporting, especially when dealing with several short-term contracts. Now, companies can choose to expense incremental expenditures if the amortization period is one year or less as a practical expedient.
Even though it is not specifically stated in the standard, some firms argue that it is regarded as an accounting policy choice if an entity chooses this technique. The same approach must be applied to all similar short-term contract acquisition expenses.
The ASC 340-40 standard has three main components:
Incremental costs: The additional costs explicitly incurred to obtain a customer contract, like sales commissions, legal fees, and certain travel expenses.
Amortization term: The standard's applicability hinges on the amortization term of incremental costs. If the amortization term is one year or less, entities can immediately expense them rather than capitalizing and amortizing them over a more extended period.
Practical expedient: ASC 340-40 provides a practical expedient, offering companies a simplified approach to accounting for these short-term contract acquisition expenses–helpful for entities with short-term contracts where the cost of tracking and amortizing these expenses may outweigh the benefits.
For subscription business specifically, consider the following:
The expense must be gradual. Only the additional expenditures incurred as a result of acquiring a contract should be capitalized.
The expense must be recoupable. On a contract-by-contract basis, management should evaluate the recoverability of incremental expenditures.
Capitalizing advertisement costs: Guidelines & disclosure requirements
Advertising is essential to promote products and brands, but it also represents a significant expenditure for many companies. The ASC 340-40 standard provides guidance on when and how advertising costs should be capitalized. The key requirements and guidelines include:
1. Qualifying costs
These costs directly relate to creating or producing advertising campaigns, like creative development, production, and media placements.
2. Measurement & amortization
Amortization is typically done on a straight-line basis over the expected benefit period. In subscriptions, the amortization period is not the contract life but rather the customer life. This analysis would include any renewal periods as typical renewal commissions are negligible compared to the initial commission and not capitalized.
3. Assessment of impairment
Companies must assess advertising assets for impairment whenever the carrying amount of the assets may not be recoverable. This could include changes in market conditions, consumer behavior, or the effectiveness of the advertising campaign. If the carrying amount exceeds the recoverable amount, an impairment loss should be recognized.
Impairments would also include contract or campaign terminations that are shorter than the amortization period. For example, if you have an annual contract or campaign that is terminated early, this would indicate an impairment as the customer's life may be three to four years.
4. Additional information & disclosures
In financial statements, businesses must provide additional information and disclosures regarding advertising costs:
Amortization method: Explain the process used and the expected periods over which advertising costs will be amortized. The recognized asset should be amortized systematically by transferring products or services to the relevant customer (ASC 340-40-35-1). The approach for establishing the amortization pattern should be compatible with determining the pattern of revenue recognition.
Impairment disclosures: If an impairment loss is recognized, disclose the amount of the loss, the reasons for impairment, and how it was determined.
Policy on capitalization: Provide a clear accounting policy on when advertising costs are capitalized and the criteria for impairment assessments.
Impairment loss on advertisements assets arising from ASC 340-40
Impairment loss plays a pivotal role in keeping the accuracy and transparency of financial statements. It refers to a decrease in the recoverable amount of advertising assets below their carrying amount.
This loss should be recognized when it is identified, taking several factors into account, such as changes in market conditions, shifts in consumer preferences, advertising campaign performance, economic indicators, and technological innovations.
By assessing the recoverable amount and recognizing impairment when the carrying amount exceeds this value, companies can reflect the true economic value of their advertising assets. It is essential for businesses to continually monitor factors that may trigger impairment and take appropriate actions to maintain the integrity of their financial reporting.
Long-term supply arrangements under ASC 340-40
Long-term contracts with customers in which a company commits to providing goods or services over an extended period significantly impact a company's financial reporting. ASC 340-40 gives crucial guidance for these contracts, ensuring that contract fulfillment costs are recognized to reflect the economic benefits they generate.
For these arrangements, you should apply the same requirements and guidelines listed above:
Identifying contract fulfillment costs
Measuring costs and amortizing them on a straight-line basis
Recognize impairment loss, if applicable
Include additional information and disclosures in financial statements
Stay compliant and in the know
Careful analysis leads to the best economics. You must be aware that each contract and contract renewal should be carefully analyzed to determine the economic life of your contract. Although these assessments can differ, recognizing costs over the asset’s life provides the clearest picture of when revenue and costs should be recognized.
Direct-to-consumer subscription businesses must approach revenue recognition differently. Revenue recognition software is the answer for any growth-minded business looking to automate subscription revenue accounting.
With high-velocity, high-volume customer contracts and seemingly endless contract modifications, revenue recognition standards an easily become more complicated.
Check out this checklist with five revenue recognition must-haves for DTC subscription businesses.