Deferred Acquisition Costs Explained in Detail

Deferred acquisition costs are a type of asset that companies record on their balance sheet. They represent the costs incurred to acquire a business or asset that will be amortized over time.

These costs can be significant, often running into millions of dollars. For example, a company may spend $5 million to acquire a new business, which will be recorded as deferred acquisition costs.

As these costs are amortized, they are spread out over the useful life of the asset. This can be a long period of time, such as 5-10 years.

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Deferred acquisition costs, or DAC, is an accounting technique used to calculate the cost of acquiring new customers or assets. This method is primarily used in the insurance industry.

In the insurance industry, deferred acquisition costs allow companies to amortize the cost of acquiring new policyholders over the duration of their contracts. This approach helps to spread out the upfront expenses associated with acquiring new customers.

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The cost of acquiring customers can be substantial, including legal fees, commissions, and other expenses. For example, when companies undertake takeovers or mergers, the cost to acquire another firm is substantial, including legal commissions, legal fees, processing charges, and other small expenses.

DAC is an important tool for insurance companies to accurately reflect the cost of acquiring new customers in their financial reports. By using this method, companies can provide a more accurate picture of their financial situation.

Here are some key points to understand about deferred acquisition costs:

To calculate deferred acquisition costs (DAC), you need to understand that it represents the "un-recovered investment" in policies issued and is capitalized as an intangible asset.

DAC is amortized over time, with the process of recognizing costs in the income statement known as amortization. This reduces the DAC asset over a number of years.

The amortization basis varies by Federal Accounting Standards (FAS) classification, with FAS 60, 97, and 120 each having different assumptions and requirements.

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DAC amortization requires an interest rate to be applied to the DAC based on investment returns, with the rate referred to as the k-factor.

The k-factor can change from year to year due to the true-up process, where expected values are replaced by realized values.

The DAC is recoverable if the k-factor is less than 100%, but if it's greater than 100% and there's no unearned revenue liability, a portion of the DAC or the total DAC has to be written off immediately.

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Accrual accounting is a method of accounting that matches income and expenses in a timely manner. This means that an incurred cost is not immediately recognized as an expense, but rather is capitalized and gradually amortized over time.

In the context of insurance contracts, certain costs are incurred to acquire new business. These costs are called deferred acquisition expenses (DAE) and are capitalized as an asset called deferred acquisition costs (DAC) on the balance sheet.

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To qualify as DAE, these expenses must vary with and be primarily related to the acquisition of new business. Examples of DAE include commissions in excess of ultimate commissions, underwriting costs, and policy issuance costs.

These costs are not immediately recognized as expenses, but are instead spread out over the lifetime of the insurance contracts. This approach tends to reduce the policy's first year strain and produces a smoother pattern of earnings.

Here are some examples of DAE:

All other expenses associated with the new business that do not meet the DAE criteria are classified as non-deferrable acquisition expenses.

Amortization is a crucial step in calculating Deferred Acquisition Costs (DAC). It's the process of recognizing the costs in the income statement over time, reducing the DAC asset. This process is known as amortization and requires a basis that determines how much DAC should be turned into an expense for each accounting period.

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The amortization basis varies by Federal Accounting Standards (FAS) classification, with FAS 60, FAS 97, and FAS 120 being the most common. Under FAS 60, assumptions are "locked-in" at policy issue and cannot be changed, whereas under FAS 97 and 120, assumptions are based on estimates that can be readjusted as needed.

DAC amortization uses estimated gross margins as a basis and an interest rate is applied to the DAC based on investment returns. This is known as the k-factor, which can change from year to year due to the true-up process.

The k-factor can be calculated using the following formula: DAC amortization rate = [present value of DAE + accumulated value of DAC]/[present value of estimated gross profits (EGPs) + accumulated value of actual gross profits (AGPs)]. If the k-factor is greater than 100%, a portion of the DAC or the total DAC has to be written off immediately.

Here's a summary of the different FAS classifications and their corresponding amortization bases:

It's worth noting that DAC amortization can be affected by the true-up process, which involves replacing expected values with realized values. This can result in changes to the k-factor and the amortization rate.

Insurance companies are required to comply with the Federal Accounting Standards Board (FASB) rule, ASU 2010-26, which provides clearer guidelines on Deferred Acquisition Costs (DAC).

Prior to this rule, DAC was described vaguely, leading companies to have difficulty interpreting which expenses qualified for deferral. This resulted in many companies categorizing most of their costs as DAC.

To meet the capitalization criteria, FASB introduced two important changes in ASU 2010-26. Examples of deferrable costs include referral commissions to external distributors and brokers, underwriting, and medical expenses.

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Prior to the introduction of ASU 2010-26, DAC was described vaguely as costs that vary with — and are primarily related to — the acquisition of insurance contracts.

This led to companies having a difficult task of interpreting which expenses qualified for deferral and often prompted a broad range of insurance firms to categorize most of their costs as DAC.

The FASB later concluded that DAC accounting was being abused and responded by providing clearer guidelines.

ASU 2010-26 was accompanied by two important changes to meet the capitalization criteria.

Examples of deferrable costs include referral commissions to external distributors and brokers, underwriting, and medical expenses.

These costs can exceed the premiums paid in the early years of different types of insurance plans.

Insurance companies are required to comply with a new Federal Accounting Standards Board (FASB) rule, ASU 2010-26, as of 2012.

The FASB allows insurance companies to capitalize on the costs of acquiring new customers by amortizing them over time.

DACs are recorded as assets — rather than expenses — and can be paid off gradually.

The FASB requires that companies amortize balances on a constant level basis over the expected term of contracts.

In the case of unexpected contract terminations, FASB rules that DAC must be written off, but it is not subject to an impairment test.

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To understand the Deferred Acquisition Cost (DAC) formula, let's break it down. DAC works by recording acquisition costs as intangible assets on the balance sheet, then amortizing them over the contract period.

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The total acquisition cost is the starting point for calculating DAC. This includes all the costs incurred to acquire new customers.

The total acquisition cost is calculated by adding up all the costs of acquiring new customers. This includes not just the direct costs, but also a portion of the costs of maintaining the insurance company's office.

To calculate the periodic amortization, we divide the total acquisition cost by the number of contract periods. This will give us the periodic amortization expense that will be recorded on the income statement each period.

The periodic amortization is calculated by dividing the total acquisition cost by the number of contract periods. This will help the insurance company spread out the cost of acquiring new customers over the life of the contract.

The costs included in DAC can vary depending on the accounting standard used, either PSAK or IFRS.

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