In 2018, Adobe performed accounting acrobatics by adopting new rules that capitalized $413 million of commissions that they had previously expensed. This change was the result of a new set of accounting standards introduced in 2014 that impacted how revenue and some related costs are recognized by all companies.
So what changed?
A set of new standards called ASC 606 completely changed the way companies account for revenue and related sales commissions. Some consider ASC 606 to be the biggest change in accounting standards in the last 100 years. (Exciting! But we still recommend you read the following post with coffee in-hand!)
Under ASC 606 ( also including related changes to ASC 340 ), companies not only have to modify how they recognize revenue, they must now include certain costs related to capturing that recognized revenue. For many businesses, those costs include sales commissions and now, businesses must capitalize certain commission costs and amortize those costs over time to match the timing of the revenue recognized. For some companies (like SaaS companies), the accounting changes for sales commissions have a bigger impact than the changes for revenues.
Companies are required to adopt these rules at different times (but can elect to do so earlier):
US public companies for fiscal years starting after 12/15/2017
US private companies for fiscal years starting after 12/15/2021 *
International companies that report under IFRS for fiscal years starting on or after 1/1/2018
Be sure to check with your accounting department to ensure that you have met the appropriate deadlines. If you're a private company, your accounting department should have recently completed or is in-process of completing its initial assessment with these new rules.
*On May 20, 2020, the FASB voted to extend the deadline by one year from 12/15/2020 to 12/15/2021.
In order to meet ASC 606 requirements and amortize commissions, companies are now forced to disaggregate much of their data. The explosive growth in data volume makes manual management of commissions extremely challenging, if not nearly impossible.
For example, let's say a company used to maintain aggregated sales data based on ARR for the month and would calculate sales commissions based on that aggregated data. Under ASC 606, that company may now need to disaggregate its data to show multiple products with differing revenue patterns (such as up-front revenues for on-premises software and overtime revenues for post-contract support). This may require breaking down commissions calculations to the contract or product level, or a reasonable estimation method to disaggregate the commission amounts.
In order to determine how to treat specific types of commissions costs, your team needs to assess three factors:
Can this cost be capitalized?
If capitalized, what is the life: contract term or expected customer benefit period?
If capitalized, what is the pattern of revenue we are trying to match?
Here are some common types of commissions and how they are treated:
After you identify the life of the commission cost, you then consider the pattern that you need to match. Here are some common examples:
After you have mapped your costs to their commission requirements, then comes the fun part! Lots of math! You simply calculate an amortization table for each commissionable amount (or portfolio of amounts) that requires capitalization.
A new logo sale with a SaaS platform product amortizes ratably over the estimated customer benefit period. The implementation services on that same contract would be recognized as delivered.
The renewal of the SaaS platform a year later amortizes ratably over the contract term.
You may be an Excel wizard, or perhaps you like mixing cake batter by hand rather than with an electric mixer because you love a good challenge. If that’s the case, you may feel that managing ASC 606 calculations is a piece of cake (that you just made with hand-mixed batter). After all, if you have four commission plans that require a benefit period of three years, that's only 144 overlapping amortization tables that you need to build.
However, for those of you who would like to save yourself the hassle of creating hundreds of amortization tables, CaptivatelQ has built a CPA-designed solution to help you adopt ASC 606 for both revenue and commission calculations. And we know that our solution works because we were the ones calculating those hundreds of amortization tables before building CaptivatelQ!
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Sales contracts contain the promised goods or services that your company agrees to provide a customer in exchange for consideration (i.e., cash!). Promised goods or services in a contract that require accounting are performance obligations or POB.
Costs that are directly incremental to obtaining a contract are required to be capitalized and matched to sales revenues. This includes sales commissions, but can also include fringe benefits, management bonuses, or anything else that's paid because of closed deals.
Want to know if something is "incremental to obtaining a contract?" Ask yourself, "Was this cost incurred directly as a result of a customer signing a contract?" Travel to a customer for sales? No. Commissions for qualified leads instead of closed-won contracts? No. Fringe benefits incurred because of a closed-won contract (like a 401k match)? Yes.
The period of time in which your capitalized commission costs need to be amortized is determined by whether the related commission is commensurate with costs that would be paid to renew the contract. If you pay a 10% commission on new logo deals (first contract) and a 2% commission on the renewal (second contract), then these commissions are non-commensurate. However, the 2% renewal commission (second contract) is commensurate with the next 2% renewal commission (third contract). A commensurate commission is recognized over the contract term associated with the related sales revenue. A non-commensurate commission is amortized over an estimated customer benefit period.
A commensurate commission is recognized over the contract term associated with the related sales revenue. A non-commensurate commission is amortized over an estimated customer benefit period.
Amortization is the process of expensing a capitalized cost over time. A list of all of the expenses (in the amount and period) is an amortization table or a waterfall.
POBs trigger revenue recognition according to a specific pattern of recognition that varies depending on the type of good or service provided. SaaS platform access or support typically has a pattern of recognition that is ratable over the term of the contract. Physical goods or on-premise software are typically recognized upon delivery. Professional services such as installation, implementation, and custom development can vary significantly but are most commonly either recognized proportionately while the services are performed or deferred until completed.
Rather than track capitalized costs for every commissionable amount, companies can group similar costs with similar recognition requirements into portfolios.
Costs should be recognized in the same period as their related revenues. For example, for a $12,000 annual contract for which you pay a $1,200 sales commission, during each month you will have $1,000 of revenue and $100 of expense for the commission to match the revenue's timing.
A capitalized (or deferred) cost is not expensed immediately. Thus, the $1,200 commission in the above example would be capitalized and shown as a deferred cost (an asset) until the expense is matched with your sales revenue.
The adoption of ASC 606 means you'll be recording a lot of commission costs as deferred costs.
The estimated customer benefit period is intended to estimate how long a customer benefits from the initial sale. In practice, this number is highly subjective. For example, SaaS and software industry companies will commonly use 3-5 years, but that timeframe can vary depending on customer churn rates and other factors.
So how do we match a capitalized cost with a customer benefit period of three years when our initial contract has a one-year term? We consider the anticipated renewals of the contract. We match the revenue pattern anticipated over a three-year life assuming that the customer were to renew his or her contract.