How to Apply a Practical Expedient For COGS Under ASC 606
This is the final blog in a series on ASC 606 outlining how to implement and leverage these standards in your accounting. In the first blog in the series, we talked about the five-step ASC 606 revenue recognition process. The second blog discusses revenue recognition examples and how to treat them under ASC 606. In the previous blog, we cover ASC 606 implications for warranties. This blog covers practical expedients under ASC 606. You can also check out: Accounting for COGS (cost of goods sold) Examples
What is ‘Cost of Goods Sold’?
Cost of Goods Sold (COGS) 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 when the related revenues are earned.
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.” Incremental costs are associated with obtaining a customer contract that the entity would otherwise not have incurred without the contract.
Other costs incurred to obtain the contract, regardless of whether the deal was signed, 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 fulfill a contract are amortized consistently 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 – Companies cannot capitalize costs if they are not tied to obtaining and fulfilling a contract or matched to a standing or past performance obligation. The costs can be recorded as an expense if the guidance does not allow the entity to capitalize on that cost. 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 other costs include operating expenses such as rent, utilities, overhead, legal, travel, and expenses.
Practical expedient ASC 606: 3 Ways to Perform COGS Analysis
COGS 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 COGS 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 and are generally recorded in the generated period. Because both COGS under practical expedient and bookings are recorded in the period incurred, accountants can 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 treatments per ASC 606, performing analysis at a more granular level can give you a more accurate view of COGS spend.
COGS is an important financial metric since it determines an entity’s gross profit and gross margin. Higher COGS equals lower margins, so accounting teams must have visibility into COGS to inform executive leadership in real time. However, COGS reporting can also change depending on the accounting standards applied.
COGS reporting is especially challenging when recognition occurs on different schedules across different operational tools. This makes it a challenge to report accurate profits. But there is a way out of this mess. Leapfin can help accounting teams convert operational transaction data across multiple platforms into ledger entries, accurately recognize revenue, and push reconciled financials into their ERP.