What is ASC 606/IFRS 15?
The new accounting standards under ASC 606/IFRS 15 support convergence between the International Standards Board (IASB) and Financial Accounting Standards Board (FASB) to create compliance with an international system.
Within the new revenue recognition principle guidance is a small section called the “incremental cost of obtaining a contract” which changes how some organizations manage their accounting for sales commissions. While sales commissions represent the biggest and most obvious expense, these revenue acquisition costs can also include legal or contract arrangement fees and bonuses – basically, any expense that’s only incurred by a company when they close a sale. To comply with the new commission expense accounting rules, companies must: track direct and incremental costs for each contract; capitalize those costs as an asset; and estimate the amortization period and record it over that term.
These CEA changes impact any company paying commissions (or other costs incremental to obtaining contracts) that is reporting under U.S. GAAP. Public companies are required to be GAAP-compliant by the FTC. However, many private U.S. businesses also need to produce GAAP-compliant accounting data, including companies preparing for an IPO or companies that need to provide financials to banks or investors. In all of these cases, companies will need to produce a GAAP-compliant record. Basically, any company that is trying to stay with the GAAP standards is affected. About 80 percent of Xactly’s customers, for example, expect they will require a certain level of change.
The effective date is January 1, 2018, and it will be one of the biggest changes in accounting standards in recent history. Thus, it is requiring those of us who took our graduate work in financial accounting back in the early 2000s to have to re-learn some of the principles that we were taught.
ASC 606 Revenue Recognition
FASB’s new single, principle-based approach to accounting for revenue from contracts with customers is a turnaround from the existing rule-based system, and auditors and consultants are providing a lot of guidance regarding the new standard in regards to how it changes revenue accounting and related disclosures:
- KPMG: The New Revenue Recognition Standard, Planning and Implementing a Successful Transition
- Deloitte: Revenue Recognition, Is your company ready? Don’t run out of time.
- PWC: Revenue recognition: Effectively managing accounting changes
Who does ASC 606 apply to?
There is a misconception by some that ASC 606 only applies to SaaS companies. While recurring revenue companies are certainly impacted, any company with contractual obligations to their customers are impacted. Robert Kugel of Ventana Research puts it succinctly:
“The new rules will affect companies that use even moderately complex contracts in their dealings with customers. They include, for example, contracts that are structured using tiered pricing or volume discounts or ones that routinely involve modifications, such as adding or dropping users, or that allow seasonal changes to services.”
With all of the guidance on the revenue recognition standards, however, it is easy to miss some of the other associated challenges - such as managing the amortization of the associated expenses related to the incremental cost of obtaining the contract in the first place.
How does ASC 606 impact sales compensation?
The matching principle requires that companies match the expenses to the revenue. The impact to commission falls under one particular piece of the standard – ‘subtopic 340-40’ – more commonly known as the costs of obtaining a contract.
Incremental Costs of Obtaining a Contract
- 340-40-25-1: An entity shall recognize as an asset the incremental costs of obtaining a contract with a customer if the entity expects to recover those costs.
- 340-40-25-2: 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).
- 340-40-25-3: 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.
- 340-40-25-4: As a practical expedient, an entity may 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.
This is the section that speaks to how companies will need to manage the treatment of the incentives paid to members of the sales team.
The vast majority of companies, however, are unprepared for the necessary detailed analysis of their commission expenses. The new standard will require the incremental costs of a contract be capitalized at inception and expensed systematically. Although this is just a small portion of the revenue recognition standard, it’s of enormous importance for businesses that pay commissions and wish to be GAAP compliant.
What data do I need to manage the acquisition expense?
First realize that spreadsheets cannot provide the end-to-end visibility necessary to capture the right data needed to comply with the new standard. As Sirius Decisions’ Dana Therrien puts it:
“If your company continues to calculate commission in spreadsheets, ASC 606 (IFRS 15) is going to be a problem! Not only will your overtasked compensation manager (you know the “single point of failure" wizard who makes all the commission magic happen every month) need to continue to calculate commission every month, but that that person will also need to differentiate commission expense by contract term, individual contributor and manager. It seems like this should be simple, but once you add in channels, overlays and other roles, it will become unwieldy.”
It is necessary for companies to track the direct and incremental costs for each revenue contract, including commissions. This means that the software used for automating commissions needs to include not only the payee and the amount, but also additional factors necessary to manage the amortization of the expenses.
This includes factors such as the term(s) of each deal contract, the company sold to and their associated vertical industry, which products and services were sold by line item, the geography/region, the contract or sale type, etc. Each line item in the contract might have a different treatment as to how it is expensed. Services that are delivered immediately might be treated one way, while delivered products would have a different treatment. Expressed and implied warranties could trigger differ amortization schedules, as could your pattern of customer turnover and contract cancellation.
The actual factors to track in your sales performance automation solution will depend on your commission expense amortization strategy.
How do I manage the amortization of the commission expenses?
Companies will need to define and document their amortization strategy. This includes the expected amortization period for different types of revenue, the different applicable associated commission expenses associated with that revenue “bucket”, and the amount of time over which to run the amortization model. Once you have determined the appropriate model, capitalize the commission expense costs as an asset and apply the amortization schedule.
To record the amortization expense(s) over that term, you need to be sure that your systems can talk to each other. This applies particularly in regards to your ERP and HRIS systems, as well as your CRM. You could be pulling information from each of these systems to make the calculations, and when done you will need to generate a report that can easily get back into the ERP system for full tracking. We covered how to do this in Xactly Incent in the last session of our 3-part webinar series on Preparing for the New Revenue Recognition Standards. This series can be watched on demand and covers the following:
- Part One: How the new standard for revenue from contracts with customers will change your commission accounting approach
- Part Two: Customer insights around the impact on plan design
- Part Three: How to approach these changes within Xactly Incent
The new commission expense accounting requirement also requires a comparison to the prior two years. This means that companies may need to incorporate a “look-back” period that shows who was paid, what was paid for, and the commission amounts per customer for years . Your model and systems will need to have the ability to re-run past data to analyze how the new standards would apply in the “look back.”
How Xactly helps with ASC 606 implementation
Managing and reporting on incentive compensation has become infinitely more complex, but Xactly is ready to automate it for you. Xactly’s sales performance management (SPM) software already has the ability to automate the tracking and monitoring of the line-item commission data needed. Xactly is committed to helping our customers keep their commission accounting GAAP-compliant under the new regulatory standard.
Xactly has put together an informative blog post on ASC 606 implementation, with related questions and answers, along with a number of resources to help businesses understand the new Revenue Recognition Principle and its impact on commission expense accounting. You can also contact us here.