How to Apply a Practical Expedient For COGS Under ASC 606
What is ‘Cost of Goods Sold’?
Cost of Goods Sold is the cost of the product or service that a company has sold and is reported as an expense on the income statement. Based on the matching principle of accrual basis accounting, a company reports an expense on its income statement in the period in which the related revenues are earned.
For more information, refer to our previous blog post: Accounting for COGS (cost of goods sold) Examples
Accounting for Costs to Fulfill a Contract Under ASC 606
Under ASC 606 section 340-40-25-1, “an entity should recognize as an asset the incremental costs of obtaining a contract with a customer if the entity expects to recover those costs.” The incremental costs are defined as costs associated with obtaining a contract with a customer that the entity would otherwise not have incurred if the contract had not been obtained.
Other costs to obtain a contract that would have been incurred regardless of whether the contract was obtained should be recognized as an expense when incurred, unless those costs are explicit to the customer (ASC 606 section 340-40-25-3).
ASC 606 section 340-40-25-5 requires companies to recognize an asset from the costs incurred if those costs meet all of the following three criteria:
- The costs relate directly to a contract or to an anticipated contract that the entity can specifically identify (e.g., costs related to direct labor or material, costs that can be allocated directly to the contract, costs explicitly charged to the customer)
- The costs generate or enhance resources of the entity that will be used in satisfying, or in continuing to satisfy, performance obligations
- The costs are expected to be recovered
The assets recognized for the incremental costs to obtain and/or fulfill a contract are amortized on a basis that is consistent with the transfer of services to which the asset relates (as revenue is recognized). For contracts in which the renewal period is one year or less and renewal costs are commensurate with the initial contract, the entity may apply a practical expedient and recognize the costs of obtaining a contract as an expense when incurred, without capitalizing as an asset.
Practical Expedient - ASC 606 section 340-40-25-4 allows that "an entity may recognize the incremental costs of obtaining a contract as an expense when incurred if the amortization period of the asset that the entity otherwise would have recognized is one year or less.” Note that the amortization period could be longer than the initial contract period when determining whether the expedient is available.
Other costs – Costs that are not costs to obtain and/or fulfill a contract, or when an entity cannot determine whether a cost relates to a past or a standing performance obligation, and other guidance does not allow the entity to capitalize that cost, the entire amount is expensed as incurred. Companies should not defer an expense solely to match that expense with the related revenue. This is the case even when the related revenue contains variable consideration that has been constrained. Some examples of other costs include operating expenses such as rent, utilities, overhead costs, legal, and T&E.
3 Ways to Perform COGS Analysis
Cost of Goods Sold is generally measured as a percentage of revenue. When applying the matching principle, this is a good benchmark or indication of COGS performance.
However, when applying the practical expedient of ASC 606 section 340-40-25-4, the metric against revenue is no longer reasonable as revenue is recognized over time while the Cost of Goods Sold is expensed in the period incurred. Alternatively, COGS can be measured as a percentage of bookings.
At a high level, bookings are the value of contracts signed in a given period of time and are generally recorded in the period generated. Because both COGS under practical expedient and bookings are recorded in the period incurred, accountants are able to review the performance of COGS using this metric across various periods.
Another option is to perform analysis by product and segregate recognition of COGS (capitalized vs expensed in period). Since different product lines can have different COGS treatment per ASC 606, performing analysis at a more granular level can give you a more accurate view of COGS spend.
Cost of Goods Sold is an important financial metric as COGS will determine an entity’s gross profit and gross margin. Higher COGS equals lower margins, so accounting teams at must have visibility into COGS to keep executive leadership informed real-time. But be sure to pay close attention to your analysis as COGS reporting will change depending on the accounting standards applied.