If you aren’t familiar with how ASC 606 regulations affect sales commissions, read our previous article by clicking here. For a detailed walk-through of how to generate an amortization schedule and become compliant, click here.
Not every aspect of ASC 606 is bad for business:
- It aligns revenue recognition with international standards
- It provides clear “triggers” and conditions for accounting actions
- It forces companies to modernize the way they manage sales commissions
However, the impact on sales commissions can be hard to understand, and it creates additional complexities for accounting. This article is an attempt at explaining some of the impact on sales commissions – in layman’s terms.
Type Of Commission & Capitalization
Sales incentives come in different forms – revenue-based percentages, SPIFFs, bonuses, kickers, MBOS (management by objective), etc. The pre-condition for capitalizing sales commissions is that associated costs should be “incremental” and “recoverable”.
The definition of “incremental” is a bit confusing. Consider a situation where a customer decides not to sign a contract at the last minute. If a cost was negated, it was “incremental”. Most sales commissions aren’t paid unless the contract is signed, which is why they qualify for the “incremental” classification.
They also are “recoverable” in the sense that the cost is expected to be recouped through execution of the contract. Unfortunately, you can see that some types of incentives (such MBOs) may not match those pre-conditions. Additional effort is therefore required to make a proper determination for each type of commission, which is a bit of a headache.
Contract Duration & Amortization
Suppose that you sell online subscriptions. Customers may sign up for your cloud-based service for an initial period of time (ex: one year). However, they may also renew their contract. In this case, paid sales commissions should be amortized based on the entire expected duration of the contract (not just the initial period). This can require estimating the average lifetime of a contract, which is not easy and may change over time.
Qualifying For Immediate Expense
Consider the time between when the entity transfers a promised good or service to a customer, and when the customer pays for that good or service. If it is one year or less, then accounting can choose to expense all sales commissions at the time the contract was signed. This helps quite a bit, but can also create additional complexities. For example, consider a domain provider, letting customers choose whether they want to reserve a domain name for 1 or 3 years. Also, the one year rule must be used uniformly. Therefore companies must ensure they have a clear policy in place to expense sales commissions.
Aligning Amortization Schedules
If your contract has different components (ex: an online subscription and a companion helpdesk option), then you must determine which sales commissions are associated with which each line item. This means you must use precise commission-to-order tracking. Also, you must align the schedule used to amortize commissions, with the one used to recognize revenue. Most companies have an accounting policy defining amortization periods so this is not too problematic, but it’s important to follow one rule.
In conclusion, the main requirement is to track the relationship between sales transactions (orders, deals, contracts) and sales commissions. To do this, you need something better than old-fashioned commission spreadsheets. For a detailed walk-through of how to generate an amortization schedule and become compliant, click here.