Estimating Commission Amortization with ASC 606
With the deadline looming, preparation for the new Revenue Recognition Standard has taken on greater urgency. One piece of the standard, in particular, has a huge effect on how companies account for their commission payments – subtopic 340-40, also known as “the incremental costs of obtaining a contract.” We’ll be taking a closer look at this small but critical component in a webinar with The CFO Alliance on June 22.
I’d like to give a preview regarding the steps companies need to take in estimating commission amortization – a key requirement of the new standard if you’re paying commissions.
Step 1: Evaluate the Compensation Strategy
Look at your products and services being sold.
If your offering is a one-time point of sale transaction, there’s no capitalization, so you don’t need to amortize any expenses under the new standard. However, many POS transactions still have a financial tail that will require capitalization, i.e. for ongoing maintenance and support. Take car sales for example. An auto company may sell a car, but that sale also includes a multi-year service plan where commission expenses must be amortized.
If your business provides a solution or service that’s going to be renewed or supported over a period that’s longer than a year, you probably need to amortize commission expenses.
Take time to understand the fiscal strategy behind your commission policy.
Sales incentive strategy isn’t an area of expertise for most accountants, but to comply with the new standard, accounting needs to understand why base and variable pay vary across compensation plans. Recognize the behaviors you’re trying to drive with different sales commissions.
Determine which plans have longer-term returns.
Identify the commission plans with payments that you expect will have value beyond the current year. These are your sales commissions that are potentially amortizable, representing your input for the amortization process.
Step 2: Evaluate How You Determine the Amortization Period
The new standard follows a principle-based approach – a big change for U.S. accountants accustomed to rule-based systems. Perhaps no area of the standard requires greater judgment than determining the amortization period.
To come up with a plan for the amortization period, accounting must evaluate the long-term benefits of the commission being paid, and identify the inputs that provide the basis of that benefit. Then, for each input, organizations must decide the typical amortization period based on contract term and anticipated lifecycle, (i.e. how long do you expect to do business with a customer above and beyond the contract term.)
There are obvious inputs and less obvious inputs that can be very complex.
In the SaaS model, some inputs are easily identified, such as the original contract term and anticipated renewals that extend the customer life.
Product turnover is a less obvious input. For example, if customers bought your product two years ago, it may not be what you’re offering today. The product itself may be obsolete, as can happen with technology products like computers and smartphones. Therefore, because what you sold two years ago may no longer be what you’re offering today, this can be a limiting factor for the amortization period.
That is, even though your customer lifetime may be longer, if the technology turnover is shorter, it can affect the input for estimating the amortization period.
Step 3: Evaluate How You Determine the Amortization Method
You don’t need to amortize expenses evenly; however, you need to make a case for your amortization methodology. For example, if you determine that the amortization period is 24 months , you could expense 1/24th each month, but it doesn’t necessarily have to be that way. Companies may expense 2/3 the first year and 1/3 the second but, whatever path is chosen, they need to be able to justify the rationale behind making that decision.
Portfolio expensing is another possible option. You may be able to group or “bucket” commissions by product type, region, or go-to-market team, and assign an amortization life for each bucket. However, to follow this approach requires a high sales volume. If you only have a few big deals a quarter, it won’t work, as there’s too much variability in the contracts and the delivery periods.
Your Customer Lifetime Affects Your Commission ROI
Why is this change required? When a company provides a sales rep with variable compensation, they can be paying the rep to bring in a customer for longer than the initial contract term. Businesses don’t expect to have customers for just one year; they expect to retain customers for a longer period of time. Your ROI on that commission payment is really determined by how long you retain a customer.
We’ve found that many companies don’t think this portion of the standard applies to them, thinking it’s limited to software-as-a-service (SaaS) businesses. That’s incorrect. Unless you’re selling a one-time POS product or service, the standard likely affects your commission expense accounting.
Join us at our upcoming webinar to learn more. Xactly has also put together a number of resources to help businesses understand the new Revenue Recognition Standard and its impact on commission expense accounting.