ASC 340-40: Contract Costs, Amortization, and Impairment

ASC 340-40 is the U.S. GAAP standard that tells a company which costs tied to a customer contract belong on the balance sheet and which hit the income statement immediately. It works alongside ASC 606 and splits contract costs into two buckets: incremental costs of obtaining the contract, and costs of fulfilling it. Each bucket has its own test, its own exceptions, and its own follow-on rules for amortization, impairment, and disclosure.

When the Standard Applies

For costs of obtaining a contract, ASC 340-40 is the primary standard. Go straight to it.

For fulfillment costs, it is residual. You use it only after confirming that no more specific guidance already covers the spending.¹ The codification names inventory (ASC 330), property and equipment (ASC 360), internal-use software (ASC 350-40), software to be sold or marketed (ASC 985-20), and preproduction costs for long-term supply arrangements (ASC 340-10) as examples of topics that take priority. If your fulfillment cost fits one of those, that topic controls and ASC 340-40 does not come into play.

Incremental Costs of Obtaining a Contract

An incremental cost of obtaining a contract is one the company would not have incurred if the deal had not closed. The codification frames this as a strict “but for” test.¹ Sales commissions are the standard example: the employee earns the commission only because a specific contract closed. If the deal had collapsed, the company would owe nothing.

Fringe benefits calculated on that commission (payroll taxes, pension contributions) are themselves incremental and get capitalized alongside it.

Costs that the company would have paid regardless of the outcome fail the test and must be expensed as incurred. That group includes bid and proposal costs, general selling and marketing expenses, advertising, and legal costs incurred while pursuing the contract.¹ Legal fees for drafting the contract trip up a lot of companies. Most are billed during the pursuit phase and would exist even if negotiations fell apart, which makes them non-incremental. Only a fee arrangement explicitly contingent on signing would pass the but-for test. Standard administrative salaries and travel to pitch a client fail for the same reason.

Commissions Subject to Clawback

A commission that can be clawed back if the customer cancels or defaults still qualifies for capitalization at signing, provided management has concluded the contract is valid and collectability is probable. The clawback provision alone does not disqualify it. If circumstances change later, the company reassesses whether a valid contract still exists and tests the asset for impairment.

The One-Year Practical Expedient

If the asset that would result from capitalizing the cost would be amortized over one year or less, the company can expense the cost immediately instead.¹ The threshold is the amortization period, not the contract term. A one-year contract that routinely renews, where the commission relates to the entire expected relationship, can have an amortization period well beyond twelve months. In that case the expedient is off the table.

Costs of Fulfilling a Contract

Once you have confirmed no other GAAP topic applies, ASC 340-40 imposes a three-part test. All three conditions must be met to capitalize:¹

The cost relates directly to a specific existing contract or a specific anticipated contract you can identify.
The cost generates or enhances resources the company will use to satisfy performance obligations in the future.
You reasonably expect to recover the cost through payments under the contract.

Costs that typically qualify include direct labor of employees providing services to the customer, direct materials consumed in delivering those services, allocations of costs tied to contract activities (contract management, insurance, depreciation of tools and equipment used on the project), costs explicitly chargeable to the customer under the contract, and payments to subcontractors triggered solely by the contract.¹ Setup and mobilization costs to move equipment to a job site often fit under these categories.

Costs You Must Expense Immediately

Some fulfillment costs never reach the balance sheet:

General and administrative costs, unless the contract makes them explicitly chargeable to the customer.
Costs of wasted materials, labor, or other resources that were not reflected in the contract price.
Costs relating to performance obligations already satisfied, in whole or in part.
Costs you cannot attribute to either completed or remaining obligations.

The wasted-resources rule catches abnormal spoilage, rework caused by errors, and idle labor on a project. If the waste was not priced into the contract, it hits the income statement as incurred.

How to Amortize a Capitalized Contract Cost

Amortization has to follow a systematic basis that matches the transfer of goods or services to the customer.¹ It is not automatically the expected life of the customer relationship. The FASB has cautioned against that presumption. The period reflects the pattern in which the company transfers the specific goods or services the asset relates to.

The period can extend past the initial contract term. If a three-year contract typically renews for two more years and the capitalized cost relates to services delivered across all five years, amortizing over five may be appropriate. The question is what the cost actually relates to, not how long the customer is likely to stay.

Several factors shape the judgment:

Size of the commission relative to contract value. A large commission relative to ongoing revenue suggests the asset relates to anticipated renewals; a small one may not.
Difficulty of switching providers. High switching costs lengthen the useful life; low switching costs shorten it.
Whether the deliverable changes significantly at renewal. Meaningful changes weaken the link between the original cost and future periods.
Ongoing customer-retention spending. If concessions and incentives are what drive renewals, the original acquisition cost’s useful life is shorter than the relationship itself.

Impairment Testing

Companies must evaluate whether the carrying amount of a capitalized contract cost asset remains recoverable. The test compares book value against the remaining consideration the company expects to receive (including amounts received but not yet recognized as revenue) minus the direct costs still needed to provide the related goods or services.¹ Where book value exceeds that net amount, the company recognizes an impairment loss for the difference.

Estimating the remaining consideration follows the same transaction price principles as ASC 606, adjusted for the customer’s credit risk. Expected renewals and extensions with the same customer are part of the calculation.

Impairment losses on contract cost assets are permanent. If conditions improve later and the asset would no longer be impaired, the company cannot reverse the loss. That no-reversal rule puts weight on getting the initial judgment right, because an aggressive write-down stays on the books even if the contract outperforms.

Disclosure Requirements

The standard requires enough information for investors to understand the costs associated with customer contracts. At a minimum:¹

Period-end balances of assets recognized from costs to obtain or fulfill contracts, broken out by main category (for example, costs to obtain contracts, precontract costs, and setup costs).
Total amortization expense recognized during the period, plus any impairment losses.
The amortization method used and the judgments behind the chosen period, including how the company determined the expected timing and pattern of service delivery.

These disclosures live in the notes to the financial statements. An outside reader should be able to trace the path from capitalization through amortization to expense recognition without guessing at the reasoning.

SEC Focus for Public Filers

The SEC has issued comment letters targeting contract cost capitalization policies, asking companies to demonstrate that their capitalized costs meet the three criteria in ASC 340-40-25-5 and relate directly to specific performance obligations.² Recurring lines of inquiry include whether capitalized costs are attributable solely to time spent on a specific project, whether recoverability is supported by the contract’s profit margin, and whether the amortization period matches the expected useful life of the related deliverable. A policy that states a capitalization conclusion without explaining how each cost meets the three-part test, how recoverability was assessed, and how the amortization period was set is the kind of disclosure that draws follow-up questions.

1
FASB. ASU 2014-09 Revenue from Contracts with Customers Topic 606
2
U.S. Securities and Exchange Commission. SEC Correspondence Ebix Inc Form 10-K and 10-Q Review