Treat incremental commissions like a fixed asset to properly account for them under ASC 606 revenue recognition standards, Ryan Dillard of technical accounting firm CBIZ ARC Consulting said in a webcast hosted by spend management company Airbase.
ASC 606 standards went into effect in 2018 for public companies and this year for private companies and nonprofits, so many startups are still grappling with implementation, and accounting for commissions is one of the pain points, Dillard said.
The challenge stems from the need to capitalize, and then amortize over time, commissions that are considered incremental expenses because they're tied to contracts with performance obligations that are met over more than one reporting period.
“That was kind of a wake-up call to a lot of our clients,” said Dillard, whose company works mainly with software-as-a-service (SaaS) technology companies. “They hadn’t thought so much about this cost aspect having to be a heavy lift.”
Incremental costs
To understand which commissions are incremental and need to be capitalized and amortized in the P&L, determine which commissions are tied directly to obtaining a sales contract, Dillard said.
Sales-related costs that aren’t directly tied to the contract, such as compensation to people to make lead-generation calls that happen whether or not the contract closes, would not be considered incremental. Nor would travel costs to make a sales pitch to a potential customer, since those costs would be incurred even if the contract didn’t close. Only the commission and any other costs — including, for example, payroll costs, or incentive pay, tied to the commission — that are incurred only if the contract closes would meet the incremental definition.
Once you have those costs identified, you have to decide the period over which they need to be amortized. This can get tricky, he said, because it depends on the length of the contract, whether or not the client is expected to renew after the contract term, and whether the technology the client is paying for changes so much during the contract period that it’s no longer functionally the same software.
“I think of it as having two goal posts,” Dillard said. “The shortest period you would probably amortize it is your initial contract period. The longest would probably be your customer life. But in reality it’s going to be something shorter than that, because there are things you need to take into consideration — some of your churn rates, changes to the technology. Is it really the same product today as it would be in four, five or six years?”
Most companies he works with assume an amortization period of four to five years, which might include an initial three-year contract period and two one-year renewals. In a case like that, if the salesperson is paid a $30,000 commission, you might expense 80% of the commission upfront and then amortize the balance over the term of the period you assume.
“You might accumulate these commissions over a month or a quarter, and then you’re going to set up that number as a kind of commission asset, and then you’re just going to bleed it out,” he said. “It’s going to look very much like a fixed asset schedule.”
Most of the companies he works with do their initial scoping in Excel, set it up in NetSuite and then give it an amortization period.
Chart of accounts
To get it right, controllers might expect to keep their normal commission process as-is in the P&L and then set up new GL accounts to track the amortizations.
“So, you’re going to have a contra-commission expense account,” he said. “You’re going to have your normal commission expense in the P&L, where it’s going to flow through. Then, you’re going to have a contra account, and that way you can track what’s being capitalized each period, what’s being pulled out and put on the balance sheet. And then on the balance sheet side, you’re going to have, just like a fixed asset, your gross commission asset that you’re amortizing, an accumulated amortization account. You have these two accounts on the balance sheet, and the contra-expense account. Then you have another amortization expense account for commissions on the P&L.”
Using this process, assuming a company had $1 million in commission expense, you might capitalize $300,000. “We can track it in the gross fixed asset, and then that amortization expense is getting picked up in your accumulated amortization account, and you have this new amortization expense account in the P&L. It’s a nice way to map everything and track it.”
