GAAP, in general, requires that costs be recognized as expense in the period that the revenue with which they are associated is recognized (the matching principle). Costs are deferred only when they are expected to be recoverable from future revenues. When applying these principles to service transactions, special consideration must be given to the different types of costs that might arise.
The major classifications of costs arising from service transactions are as follows:
- Pre-contract or pre-engagement costs. These are costs that are incurred before the service contract (or engagement letter in many professional services firms) has been executed between the parties. They can include legal fees for negotiating contract terms, costs of credit investigations, and the salaries and benefits of individuals involved in negotiating contracts with prospective clients.
- Direct costs. Costs that are specifically attributable to providing service under a specific contract or contracts. For example: this would include service labor and repair parts on a fixed-price maintenance contract.
- Indirect costs. Costs that are incurred as a result of all service activity but that are not directly allocable to any specific contracts or engagements.
- Out-of-pocket costs. Costs incurred incidental to the performance of services that are often reimbursable to the service firm by the customer either at actual cost or at an agreed-upon rate (e.g., meals, lodging, airfare, taxi fare, etc.).
- Overhead. General costs of running the business that do not fall into any of the above categories, often referred to as selling, general, and administrative expenses. These include uncollectible receivables, advertising, sales commissions, and facility costs (depreciation, rent, maintenance, etc.).
The costs listed above are accounted for as follows:
- Pre-contract or pre-engagement costs. Expense as incurred as start-up costs under SOP 98-5 for all of the service revenue recognition methods.
- Direct costs. Expense as incurred under all of the service revenue recognition methods because of the close correlation between the amount of direct costs incurred and the extent of performance achieved. Direct costs incurred prior to performance, referred to as initial direct costs (e.g., expendable materials purchased for use on the job/engagement that are purchased and held by the service enterprise as a form of inventory), are deferred and recorded as prepayments (or supplies inventory, depending on the nature of the item). Under the specific performance or completed performance methods, these costs are recognized as expenses at the time of service performance at the point that revenue is recognized. Under the proportional performance method, initial direct costs are charged to expense in proportion to the recognition of service revenue (i.e., by applying the ratio of revenues recognized in the period to total expected revenues over the life of the contract).
- Indirect costs. Under all of the revenue recognition methods, indirect costs are expensed as incurred.
- Out-of-pocket costs. Under all of the revenue recognition methods, out-of-pocket costs are expensed as incurred with the related client billings presented as revenue in the statement of income.
- Overhead. Under all of the revenue recognition methods, overhead is expensed as incurred.
Losses on service transactions are recognized when direct costs incurred to date plus estimated remaining direct costs of performance exceed the current estimated net realizable revenue from the contract. The loss (given as the Direct costs incurred to date + Estimated remaining direct costs – Estimated realizable revenue) is first applied to reduce any recorded deferred costs to zero, with any remaining loss recognized on the income statement and credited to an estimated liability.
Initiation And Installation Fees On Services Transaction
Many service transactions also involve the charging of a nonrefundable initiation or activation fee with subsequent periodic payments for future services and/or a nonrefundable fee for installation of equipment essential to providing future services with subsequent periodic payments for the services. These nonrefundable fees may, in substance, be partly or wholly advance charges for future services.
- Initiation or Activation Fees – If there is an objectively determinable value for the right or privilege granted by the fee, that value is recognized as revenue on the initiation date. Any related direct costs are recognized as expense on the initiation date. If the value of the right or privilege cannot be objectively deter mined, the fee is recorded as a liability for future services and recognized as revenue in accordance with one of the revenue recognition methods.
- Installation Fees – If the equipment and its installation costs are essential for the service to be provided and if customers cannot normally purchase the equipment in a separate transaction, the installation fee is considered an advance charge for future services. The fee is recognized as revenue over the estimated service period. The costs of installation and the installed equipment are amortized over the period the equipment is expected to generate revenue. If customers can normally purchase the equipment in a separate transaction, the installation fee is part of a product transaction that is accounted for separately as such.
Example of Installation Fees
Lie Dharma Corporation has invented a nitrogen injection device for resealing opened wine bottles, calling it NitroShell. The device is especially useful for restaurants, which can seal wine bottles opened for customers who want to take home unfinished wine. Because the NitroShell device is massive, Lie Dharma pays a third party to install each unit for a fixed fee of $200, charging restaurants a $300 nonrefundable installation fee plus a monthly fee for a 20-month cancelable contract.
The initial entries to record an installation charge from a supplier and related installation billing to a customer are as follows:
Lie Dharma recognizes the installation revenue and associated installation expense for each installation in 1/20 increments to match the contract length, each with the following entry:
[Debit]. Unearned installation fees = 15
[Credit]. Installation revenue = 15
[Debit]. Installation expense = 10
[Credit]. Installation asset = 10
A customer cancels its contract with Lie Dharma after five months. As a result, Lie Dharma accelerates all remaining amortization on the installation asset and recognizes all remaining unearned installation fees at once, using the following entries:
[Debit]. Unearned installation fees = 225
[Credit]. Installation revenue = 225
[Debit]. Installation expense = 150
[Credit]. Installation asset = 150
If the service contract had included a clause for a refundable installation fee, then cancellation after five months would still have resulted in immediate acceleration of amortization on the installation asset. However, the unearned installation revenue could not be recognized. Instead, the following entry would have recorded the return of the installation fee:
[Debit]. Unearned installation fees = 225
[Credit]. Cash = 225