If you work in the field of sales commissions, you’re likely aware of ASC 606, the five-step revenue recognition model and timelines.
The basic premise on which both ASC 606 and IFRS 15 have been formulated is that an organization can recognize revenue from a customer contract only when the customer is satisfied. Also, the incremental costs of obtaining a contract — sales commissions — must be amortized only when the related revenue is recognized. It makes the simple process of expensing sales compensations a lot more complex.
Over last few months, I’ve worked with several customers in getting their processes and systems ready for ASC 606 compliance. I’ve come to realize that TRG, a group of accounting professionals, has published several papers on how to recognize revenue from customer contracts, but there is little guidance on sales commission.
Here are five important aspects of ASC 606 as related to the world of sales compensation.
1. Capitalizing costs. Within ASC 606 is a sub-chapter titled ASC 340-40-25 that prescribes how the costs related to obtaining a contract should be capitalized. According to ASC 340, these costs can be capitalized only if the costs are recoverable — the customer will pay for it as the contract is fulfilled over the period — and incremental — they arise only if the contract is signed.
For instance, any travel costs incurred during sales cycle or the base salary for the sales person are incurred even if the customer decides not to sign the contract. Hence, these can’t be categorized as incremental, and must be paid.
Sales commissions meet both of the above criteria, so must be capitalized. However, you must evaluate the definition of your SPIFFS, MBOS and KSOs to determine if those are incremental and recoverable, If they are, those must also be capitalized.
2. Contract renewal. In subscription economy, most companies pay sales commissions when the customer first signs the contract. When a customer renews the contract, there is little or no renewal commission paid to the sales rep who got the initial contract. In such situations, how can one capitalize the initial commission paid? There are two points to consider:
- Do you pay additional commission when the contract is renewed? How much?
- If you don’t pay an additional commission, what is the expected life of the contract?
It is important to understand this concept of expected life of the contract. Based on what you know about this customer and your track record with similar customers, you should make a judgment call to figure out how long this customer is expected to stay. The commission cost should be expensed over the expected duration of the contract, and not the initial duration.
If the commission paid at the time of renewal is equal to the commission paid at the time of the original contract, then you don’t have to get into the complexity of expected duration. In that case, the original commission can be amortized over the initial duration, and the renewal commission can be capitalized when the contract is renewed.
In other words, if there is a high probability of a customer renewing the contract, and there is no renewal commission, you should amortize the commission over the expected duration of the contract.
3. Practical expedient clause. Costs of obtaining a contract can be expensed right away if the amortization period is one year or shorter. It’s an option that your accounting can choose to expense entire sales commission right away. For example, if a company sells hardware with one-year warranty, it has the option to expense entire revenue and related sales commission at the time of contract signature.
If you chose this option, you must be consistent and all contracts one year or shorter must be expensed right away.
4. Timing of commission payment. In most cases, commission is earned when the contract is signed, but it’s paid at the end of the quarter or year. At what point should this commission be capitalized? Per TRG, the timing of actual payment does not affect when the cost should be capitalized, nor does it impact the amortization schedule.
For example, ABC Inc. pays a 4 percent commission on a two-year contract. Two percent is paid at contract signature and the balance after six months. For ASC 606, the entire 4 percent should be capitalized at contract signature and amortized over two years. It can be amortized on a quarterly or annual basis, per your accounting policy.
5. Amortization schedule. Commission amortization is a two-step process:
- Determine the commission cost for each performance obligation in the contract. If the contract mentions software, support and upgrade as three distinct items committed to the customer, you have to calculate how much commission is paid for each item separately. Some judgement and VSOE concept may be needed to determine this.
- For each performance obligation in the contract, recognize the commission cost only when the related revenue is recognized. The schedule for commission amortization must match the schedule for revenue recognition.
If your company already has a software for commissions, it should be relatively easy for you to get in compliance with ASC 606. It requires some collaboration between the accounting and commissions teams. If you are in sales compensation and are not yet prepared for ASC 606, you should act fast. Public companies in US are required to comply with ASC 606 guidelines for their first quarter 2018 reporting.
Register for my on-demand webinar, “ASC 606 and IFRS 15: The Impact on Sales Compensation.”