Why Implement a Commission Policy?
Like a revenue policy, a commission policy is a living document that helps you enforce the consistent application of FASB guidelines (specifically ASC 606).
This document functions as an internal control that will dictate how your company accounts for expenses related to acquiring and fulfilling contracts, and it will serve as a point of reference during audits.
What Does ASC 606 Say About Costs/Expenses?
Similar to its treatment of revenue, the FASB’s ASC 606 guidance has changed the way companies are required to capitalize and amortize costs/expenses.
Specifically, the FASB introduced ASC 340-40 “Other Assets and Deferred Costs (“ASC 340”), which provides guidance on contract costs that are not within the scope of other authoritative literature.
The guidance in ASC 340-40 is only applicable to the costs incurred that relate to a contract or contract element with a customer. This guidance relates to costs of obtaining a contract as well as guidance on how to account for costs of fulfilling a contract with a customer.
As you’ll see, there are certain costs associated with obtaining and fulfilling a contract that can be accounted for in the period which it was incurred; however, some costs, such as sales commissions, must be capitalized over what is known as the “useful life of a contract.”
The following steps and associated sample policy will walk you through how to differentiate between costs that can be accounted for when incurred and costs that need to be capitalized.
Step 1: Identify the costs of obtaining a contract
There are many costs associated with obtaining a contract. Sales and marketing expenditures stand out as the obvious ones, but there are also things such as trial/POC costs, support costs, and others to consider when determining what exactly goes into the cost of obtaining a contract.
As a general rule, the following expenses should be capitalized and amortized:
One-time spiffs/bonuses related to sales
Fringe benefits related to the commission, spiff, and bonus payouts
Third-party referral amounts
These expenses should be expensed when incurred:
Marketing costs for lead generation
Sales & marketing salaries
Note: Companies need to consider which costs are considered incremental. While the most obvious expenses are direct commissions paid in exchange for a contract, many auditors will apply additional scrutiny surrounding fringe benefits (ex: payroll taxes, 401k matches, pension contributions, etc.). Depending on your specific circumstances, you may be required to capitalize these additional costs. Other common questions encountered by the Transition Resource Group (“TRG”) of FASB, which may be applicable to your company, were the following:
Should commissions subject to clawback be capitalized?
Should renewal commissions be capitalized?
Which costs to obtain a contract are considered incremental?
If the costs are contingent on future events, are they considered incremental?
These questions are addressed in the FASB TRG memos.
Step 2: Identify the costs of fulfilling a contract
For many companies, this step is fairly straightforward. If your costs support other business functions and are not directly related to a single customer contract, you likely won’t need to capitalize them. However, If your business is in the practice of specifically allocating your employee’s time or other resources to the ongoing support of a single customer, you may have fulfillment costs that qualify for capitalization.
Step 3: Determine the useful life of a contract
The useful life of a contract will be different for every company. This can be determined by looking at historical contract lengths and average customer retention data across the different business segments your company serves.
The useful life of a contract is between the initial contract term and the average life of a customer. The average life of a customer can be calculated by taking (1 / Gross Churn Rate).
If your company has high customer retention, it’s not uncommon to have a wide range between the initial contract term and average customer life. For example, if you have an average initial contract term of one year, and 90% customer retention, your useful life will be somewhere between 3 and 10 years. That can be a wide range, and how is someone supposed to determine where their useful life falls in that seven years?
Well, thankfully the TRG provided this little piece of guidance:
“In most industries, the goods and services that an entity was providing two decades ago are very different from the goods and services the entity currently provides to its customers… The staff thinks it is unlikely that a commission paid twenty years ago has any relationship to the goods or services provided today.”
What does that mean? It means, in the 3 to 10-year range above, you’ll likely be able to justify a useful life closer to the lower end of the range, especially if you enhance your products on a regular basis.
Step 4: Capitalize, amortize, and periodically review costs for impairment
Like all assets, capitalized commissions must be reviewed periodically for impairment. If you’ve paid commission on a new order, and the customer makes a substantial change to the original order before the end of the term (termination/downgrade), you may need to adjust the balance of your asset downwards.
You’ll need to have a systematic approach for identifying any impaired assets if your customers terminate or cancel their original agreements early.
Capitalized balances should be reviewed monthly for impairment and adjusted accordingly if the impairment is determined to exist due to a customer downgrade or cancellation before the end of the original term.