Time is up to become compliant with ASC 606 and its subtopic ASC 340-40, which specifies how companies should account for and recognize the costs associated with its revenue contracts. Public companies have had to be compliant with ASC 606 since 2018 for calendar year-end companies, while private companies’ required adoption is 2019. For private companies this means that their first year of audit under the new standard will occur in the next few months of 2020.
ASC 606 represents a fundamental shift in how commissions are accounted, tracked, and reported. Excel is no longer a viable option for most because commissions may need to be tracked and reported for several years
Many people incorrectly assume that capitalizing commissions under ASC 606 is just a SaaS (software-as-a-service) problem. While the SaaS industry has one of the biggest impacts, many other industries with other ongoing performance obligation may also be impacted (e.g. ongoing maintenance, PCS, or anything else that isn’t a one-time sale).
Are you ready for ASC 606 and its impact on commissions? Here is our 10 step guide to understanding and getting compliant with ASC 606 for commissions.
STEP 1: Understand and Analyze Compensation Plans
Gather your historical commission data so you can understand how commissions payments are calculated and the purpose of the incentive. Once you gather the data then talk to your VP of Sales to ensure you understand all components of the commission plans and how variable compensation is paid. This understanding is a critical step to ensuring ASC 606 compliance.
Since adoption of ASC 606 may require going back to several years of historical commissions data, having an Incentive and Commission Management (ICM) tool is critical. I suggest looking at Spiff 😊.
Once you have all the variable compensation data and deeper understanding of the compensation plans, you are equipped to move onto step 2 and bucket your different types of commissions (“portfolios”).
STEP 2: Bucket Your Commissions into “Portfolios”
What is a “portfolio”? We define a portfolio in the context of ASC 606 as a commissionable component that may have a different time value in the eyes of the customer. Below are some examples of what might be defined as a unique portfolio.
New Annual Recurring Revenue (ARR)
MBOs (Management by Objective)
SDR/ISR Meeting Set-up
Start by looking at your historical data and grouping all of your commissions. This will likely require additional follow up with sales and other departments. While commissions are the primary cost that will likely be capitalized, other variable compensation elements may need to be capitalized as well.
STEP 3: Determine if the Commission is an “Incremental Cost”
ASC 340-40 states the following:
The incremental costs of obtaining a contract are those costs that an entity incurs to obtain a contract with a customer that it would not have incurred if the contract had not been obtained (for example, a sales commission).
Costs to obtain a contract that would have been incurred regardless of whether the contract was obtained shall be recognized as an expense when incurred, unless those costs are explicitly chargeable to the customer regardless of whether the contract is obtained.
Some costs would have been incurred whether or not the contract was signed. The best question to ask yourself for this step is, “If both parties walked away from the contract right before it was signed, would the commissions still be paid out?”.
Here are two examples:
Example 1: An SDR receives a commission for setting up a meeting with a prospect.
In this example the SDR gets paid regardless if a contract is eventually signed with the prospect; therefore, it is not an incremental cost to obtain a contract and should be expensed as incurred.
Example 2: A sales rep receives a commission payment 6 months after a contract is signed.
In this example the sales rep gets paid only if the contract is signed. The timing of the payment is irrelevant. An asset should be created when the related commission is earned and accrued.
STEP 4: Accrual Timing Doesn’t Change
A common question we hear is “When do I capitalize a commission under the new rules?”. The answer is simple. When you accrue for commissions remains unchanged. If the commission is capitalizable then you likely should capitalize at the point of accrual (which hasn’t changed).
STEP 5: Determine the Amortization Period
Determining the amortization period (sometimes known as the “period of benefit”) for the incremental costs to obtain a contract requires significant judgement so understanding the accounting purpose behind this period of benefit is critical.
The accounting guidance says the below on the amortization period.
The FASB explained that amortizing the asset over a longer period than the initial contract would not be appropriate if an entity pays a commission on a contract renewal that is commensurate with the commission paid on the initial contract.
An asset recognized in accordance with paragraph 340-40-25-1 or 340-40-25-5 shall be amortized on a systematic basis that is consistent with the transfer to the customer of the goods or services to which the asset relates.
Guidance within 340-40-25-4 allows an entity, as a practical expedient, to 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.
As noted in the guidance above, determining an asset’s amortization period requires an analysis of historical data and a significant amount of management judgement. Given the level of judgement and materiality of the amortization period, it is usually disclosed in a company’s financials as a significant estimate.
How should you determine the amortization period for each of your portfolios?
Start by determining if the commission associated with the renewal is commensurate with the initial commission. This usually means the rate is nearly the same for the original contract and the renewal. If the commission is commensurate then it is easy. The amortization period equals the contract term. In practice this is not usually the case because commissions paid on renewals are typically substantially lower than the original commission.
If the commissions are not commensurate, then you need to determine the expected customer life. An overall average across customers may be acceptable if they all share similar characteristics and churn behavior, but further segmentation by location, size, etc. might be needed.
The expected customer life is the upper bound of the amortization period. Other factors should also be considered to determine the amortization period. The most significant limiting factor on the amortization period is the technology life.
For example, if after three years the product is substantially different from the product originally purchased product then the commission paid out on the original contract is no longer relevant, so the amortization period would be limited to about three years.
Most of all companies end up at the bottom of the flowchart with the life of the technology being the biggest limiting factor.
STEP 6: Capitalizing Fringe Benefits
As mentioned in the definition above, costs that are incremental and recoverable may require capitalization. This definition extends to costs such as employer taxes, 401(k) matching and others if they wouldn’t have been incurred if the contract wasn’t signed.
So how do most companies implement this guidance without making it overly complex?
Most companies are NOT tracking each individual incremental taxes, 401(k), etc. that is associated with each commission. Rather, companies come up with an average percentage uplift for each additional cost or as an aggregate and applies that percentage to each asset.
Example: A company determines that on average there is an additional 4% of incremental costs related to employer taxes and 401(k) matching.
Based on the above, if a sales rep closes a deal and receives a $100 commission then not only should you capitalize the $100 but you should also capitalize an additional $4 ($100 * 4%) and amortize it over the same amortization period.
STEP 7: Allocating Costs to Multiple Performance Obligations within a Contract
In this step there is some diversity on how companies may handle it and the TRG (Transition Resource Group) have issued alternative views for adoption. The below example is from the TRG on the different views.
There are several potential alternatives that the guides point to as being acceptable:
- Allocate based on relative stand-alone selling price
- Applying a single measure of amortization considering the pattern of transfer of all of the distinct goods or services to which the asset relates
- Specific allocation basis. If an entity can objectively determine that a contract cost asset relates specifically to one or more distinct goods or services in a contract, but not all then it may be reasonable to allocate the contract cost asset entirely to that (or those) distinct goods or services
If number 3 is applicable to you (often it is) then it is likely the easiest option. An example of this is if you pay a certain commission for software and a different one for professional services. Plus, if you can get away with not doing any allocation then it is one less thing for your auditors to get excited about😊.
STEP 8: Dealing with Change in Estimates
Estimates often change. Churn happens. If it is material, then adjustments may need to be made. Companies need a systematic way to apply changes in estimates and make adjustments, otherwise it will be an administrative nightmare. You will need proper controls to ensure these changes are detected and adjusted on a timely basis.
This is another HUGE reason to stop using excel and move to a system capable of handling these changes. Make sure your ASC 606 commission tool is sophisticated enough to handle these changes in estimates and adjustments. Again…I recommend looking at Spiff for this…
STEP 9: Flexible and Auditable Reporting
There are several ways that you will want to slice your data either for financial disclosures or for ongoing analysis in order to stay ASC 606 compliant.
If you are doing ASC 606 commission capitalization in excel then you are going to have a real hard time getting the data you need and getting your auditors comfortable. And if you are using a tool for capitalized commissions then make sure it has sufficient reporting functionality to meet your needs in the future.
Reporting is often an afterthought when evaluating software tools, but for ASC 606 it is critical.
STEP 10: Talk to Your Auditors Before You Implement!
The Accounting team should put together a memo for how it plans to adopt (detailing the steps above) and get auditor sign-off before implementing it into the system. Adopting the standard is no quick or simple task. Make sure you do it right the first time.
Most companies and accounting teams have been focused on the revenue impact of ASC 606 but the commission impact is often more material and requires a substantial amount of work. Delaying adoption is no longer an option. Determine your accounting impact and choose a system that can handle your needs.