Under the new Revenue Recognition Standard (ASC 606), companies must account differently for sales commissions. Here is everything you need to know to comply.
With the Revenue Recognition Standard, we’re facing one of the biggest changes in accounting standards in U.S. history. The FASB’s new single, principle-based approach to accounting for revenue is a turnaround from the existing rule-based system. A lot of guidance has been made available around the new standard in regards to how it changes revenue accounting and related disclosures.
However, the vast majority of companies are unprepared for one particular piece of the standard – ‘subtopic 340-40’ – more commonly known as the costs of obtaining a contract. 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. And companies simply aren’t ready.
In a recent survey, Xactly found that while over 80 percent of organizations say they must make changes in order to comply, only about 20 percent of them have even started to address the problem.
Increasing Complexity and Judgment for Commission Accounting
If your business pays commissions as part of its compensation, you must conduct a thorough evaluation of your company’s commission expense strategy to determine if you need to make changes in order to comply with the new reporting standard.
In short, for many businesses that simply expense commissions today, it could mean that you have to capitalize your incremental costs of a contract at inception and expense them systematically as you provide the goods or services to the customer. Because the most common commission strategies include premium amounts paid for the acquisition of new customers, you may be required to expense those amounts over the life of your customer.
This significant change in approach impacts your commission accounting process and can dramatically affect your company expenses. Right now, companies typically expense their commissions in two ways – as a period cost at the time of sale; or over the life of the contract (either way has been acceptable, as long as it was being done on a consistent basis).
Under the new standard, companies must:
- Track direct and incremental costs for each revenue contract
- Capitalize these costs as an asset
- Determine the expected amortization period and record it over that term
To meet these requirements, you need access to all the necessary data, an understanding of your sales compensation strategy, and the ability to expense costs over time.
Can You Access the Right Data?
With the new standard, companies are now required to account for commissions to a much deeper level of detail. Rather than simply aggregating payments to the rep level, companies need to account for commissions to the customer and, probably, even the order level.
Subsequently, in order to properly expense commissions, you need to be sure that your system provides the data you need to measure and track transaction details. Additionally, because the regulations include a ‘look-back’ period, companies must make sure that they have commission data going back two years before the standards go into effect.
So, even though the new standard for most companies won’t be applicable until their 2018 statements, they still need to provide a comparison for commission data from 2016 and 2017.
What’s Your Sales Compensation Strategy?
Today, if you pay commissions, you most likely expense costs, along with associated payroll taxes, as contracts are closed. In the future, you will need to capitalize at least some portion of the cost as an asset. Because accounting staff must now make judgments and estimates, they need greater understanding into the organization’s sales compensation plan.
To correctly interpret the use of dollars, they’ll want to know why Joe gets paid a higher percentage of commission than John. Accounting must also understand the expected lifetime for a customer and whether they need to capitalize commissions for anyone other than sales people, i.e. managers or sales engineers.
In addition, any time that there is a modification to the contract or the customer relationship changes, you need to reevaluate your accounting methodology. For example, if you have add-on sales, contract extensions or cancellations, accounting will need more financial details to support their disclosures to quantify the assets recognized and the commissions accrued.
How Will You Determine and Manage the Amortization?
In addition to accruing commission costs as assets, accounting also needs to expense them over a timeframe that is based on determining how the various payments benefit the company over time. This is similar to how amortization of goodwill is handled.
The standard states that amortization needs to be on a systemic basis consistent with the transfer of goods or services to the customer. But, the FASB has also issued clarifications to the standard that could increase the amortization period if the goods or services are provided under a specifically anticipated future contract. In layman’s terms, this means that the amortization period can be longer than the contracted term of the delivery.
Further adding to the complexity, let’s say that you’re paying commissions based on the individual performance obligations of a contract. But, the delivery of those performance obligations is independent. In that case, the amortization may need to be split for those obligations and recognized over different terms.
Companies Must Prepare Now
The new commission expense accounting requirements bring complexity and judgment to an area of accounting that was previously straightforward. Because a revenue contract can range from a large complex contract, with massive legal documentation, to a routine retail sale that can be done in five minutes, the standard is applicable to almost every company selling something.
A lot of attention has been given to revenue recognition as a whole, but most companies aren’t well informed about the changes needed for commission accounting. Yet, if businesses don’t adhere to these changes, you won’t be fully GAAP-compliant. With a ‘look-back’ period that’s already here, companies must make sure that they have the necessary systems and procedures in place to comply today.