A construction company has already delivered and had accepted the first of three phases under a contract. During work on the second phase, it discovers that materials used in the already-completed first phase were defective and must be replaced at the company's own cost, with no additional billing to the customer. Under ASC 340-40-25-8, how should the company account for the cost of replacing the defective materials from the completed first phase?
- Capitalize the replacement cost as part of the fulfillment-cost asset for the second phase, since both phases are under the same contract
- Add the replacement cost to the transaction price allocated to the third phase, spreading it over the remaining performance obligations
- Recognize the replacement cost as an expense when incurred, because it relates to a performance obligation that has already been satisfied rather than to a future performance obligation
- Recognize the replacement cost only if the customer agrees to reimburse it, and expense it if reimbursement is refused
Why C? And why not the others?
Correct answer: C. Recognize the replacement cost as an expense when incurred, because it relates to a performance obligation that has already been satisfied rather than to a future performance obligation
ASC 340-40-25-8 requires that costs relating to satisfied or partially satisfied performance obligations in the contract, meaning costs of past performance, be expensed as incurred rather than capitalized, and correcting defective materials in an already-completed and accepted phase is exactly that kind of cost; it does not generate or enhance a resource that will be used to satisfy a future performance obligation, which is the test in 25-5 that fulfillment-cost assets must meet. Capitalizing the cost against the second phase's fulfillment-cost asset improperly attaches a cost of fixing past work to a future performance obligation it has nothing to do with. Spreading the cost over the third phase through the transaction price confuses cost recognition with revenue allocation and again misattributes a past-performance cost to future obligations. Whether the customer agrees to reimburse the cost is irrelevant to how the cost itself is classified under the fulfillment-cost guidance; any reimbursement would be accounted for separately as consideration, not as a condition for expensing a cost that already fails the fulfillment-cost criteria regardless of reimbursement.
Source: FASB Accounting Standards Codification: ASC 340-40-25-8, Other Assets and Deferred Costs — Contracts with Customers