Impact of ASC 606 and IFRS 15 on Sales Commission Accounting
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The International Financial Reporting Standards 15 or IFRS 15 and ASC 606 are guidelines on revenue recognition issued by two key global financial regulators. This guidelines has a huge impact on how you account your team's sales commissions. View this guidebook to learn more about it.
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Impact of ASC 606 and IFRS 15 on Sales Commission Accounting
- 1. Tuesday, December 7, 2017 at 2:00 p.m. EST
- 2. AGENDA Introduction to ASC 606? 5 Step Model for Revenue Recognition ASC 340-40: For Sales Compensation Real Life Situations for Commissions Challenges in Implementing ASC 606 Technology Solution
- 3. ASC 606 and IFRS 15: The Impact on Sales Compensation What is ASC 606 and IFRS 15? The International Financial Reporting Standards 15 or IFRS 15 and ASC 606 are guidelines on revenue recognition issued by two key global financial regulators The Financial Accounting Standards Board (FASB) 1 The International Accounting Standards Board (IASB) 2
- 4. ASC 606 and IFRS 15: The Impact on Sales Compensation Convergence Joint project between IASB and FASB Establishes a single, comprehensive framework for revenue recognition To be applied consistently across transactions, industries and capital markets, and will improve comparability in the ‘top line’ The IASB and the FASB have formed Transition Resource Group a group of external stakeholders to identify and discuss issues that may arise
- 5. ASC 606 and IFRS 15: The Impact on Sales Compensation Sales Compensation Problem Every Company has a different type of Sales Compensation Program. ASC 606 does not explicitly address considerations for different types of commission programs GAAP Rule Based Complex Standards Principles Based Standards Judgement Capitalize or Expense? Amortization Period? AAC 606 IFRS 15 Accountants Have to Understand SPM Commissions Manager Have to understand ASC 606
- 6. ASC 606 and IFRS 15: The Impact on Sales Compensation ASC 606 Core Principle An entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that truly reflects the revenue that the entity expects to be entitled in exchange for those goods or services
- 7. ASC 606 and IFRS 15: The Impact on Sales Compensation The 5-Step model Framework for revenue recognition
- 8. Example of Step 1 to 5 : Packaged Software Sales ABC Inc sells packaged Software. A customer buys the software package, with 2 year support and 1 upgrade, for the ‘bundled price’ of $50K. Customer pays at contract signature. How should this revenue be recognized under ASC 606? Step 1: Contract Step 2: Identify Performance Obligations # 1 Software / Contract Signature # 2 Upgrade / End of Year 1 # 3 Customer Support /End of Year1 and Year 2 Step 4: Allocate Price to each Obligation Determine Fair Market Value of each item in the bundle (think VSOE) FMV of Software License $70K (70%) FMV of Upgrade $20K (20%) FMV of 2 Year Support $10K (10%) Step 4: Allocate Price to each Obligation (contd..) Calculate revenue for each PE for this Contract Software: 50K * 70% = $35K Upgrade: 50K * 20% = $10K Support: 50K * 10% = $ 5K Total: $50K Step 5: Recognize Revenue At Contract signature: $35 K (for Software) At the end of Year 1: $10 K (for Upgrade) At the end of Year 1: $2.5K (for support – 50%) At the end of Year 2 $2.5K (for support – 50%) -------------- $50 K ASC 606 and IFRS 15: The Impact on Sales Compensation Step 3: Determine Transaction Price
- 9. AGENDA Introduction to ASC 606? 5 Step Model for Revenue Recognition ASC 340-40: For Sales Compensation Real Life Situations for Commissions Challenges in Implementing ASC 606 Technology Solution
- 10. ASC 606 and IFRS 15: The Impact on Sales Compensation ASC 340- 40 -25 : Costs of Obtaining a Customer Contract Capitalize the cost of obtaining a contract if Recoverable AND Incremental Recoverable - Customer will pay for it as the Contract is fulfilled over the period Incremental - Arise when contract is obtained AND would NOT arise if contract NOT obtained Sales Compensation meets both above criterion Entities that expense commissions as it is paid, may now have to capitalize Costs that would have been incurred even if the Contract was not obtained can NOT be capitalized.
- 11. ASC 606 and IFRS 15: The Impact on Sales Compensation ASC 340-40-25: Costs of Obtaining a Customer Contract - Examples Cost Category Incremental? Recoverable? Capitalize? Legal Fee to draft the Proposals/Contracts NO NO NO Travel Fee during Sales Cycle NO NO NO Salaries for Sales Team NO NO NO Sales Commission YES YES YES
- 12. ASC 606 and IFRS 15: The Impact on Sales Compensation Costs of obtaining contract can be expensed if the amortization period is one year or less Example : Computer Sales with 1 year Warrant Sales Compensation in ASC 606: Practical Expedient Clause
- 13. ASC 606 and IFRS 15: The Impact on Sales Compensation 1. Commission Paid in Future 2. Commission for Contract Renewal 2 Real Life Situations in Sales Compensation
- 14. ASC 606 and IFRS 15: The Impact on Sales Compensation #1 - Commission Paid in Future Commission is earned when the Contract is signed but paid at the end of the quarter or year. At what point should the commission be capitalized? Per TRG – “…the timing of actual payment does NOT affect when the cost should be capitalized, nor it impacts the amortization schedule..” Example: ABC Inc pays 4% commission on 2 year customer contract worth $50K. Half the commission (i.e., 2%) is paid upon contract signature, and the remaining half after six months. Entire 4% i.e. $2K should be capitalized at the time of Contract signature, and amortized over two year period.
- 15. ASC 606 and IFRS 15: The Impact on Sales Compensation # 2 Contract Renewals Most companies pay sales commission when the customer first signs the Contract. Customer renews the contract again and again, but there is no commission paid at the time of renewal. How should this commission be amortized? Points to Consider Is Commission paid at the time of renewal? How much? If there is no commission at the renewals, what is the expected life of the contract?
- 16. ASC 606 and IFRS 15: The Impact on Sales Compensation Contract Renewals - Example ABC Inc, sells software as a service. It pays 4% of contract value as commission. A rep signs up a new customer for a 2 year contract for $50,000. How should this commission be amortized? Case Renewal Commission Expected Duration ASC 606 Recommendation 1 No commission at renewal 4 Years Capitalize $2K, to be amortized over the 4 year period 2 Additional 4% 4 Years Commission paid at the time of renewal is commensurate with the initial commission, and hence the initial commission of $2K should be capitalized to be amortized over 2 year period. When customer renews, the additional commission should again be capitalized. 3 Additional 2 % 4 Years Commission at the time of renewal, is Not commensurate with initial commission, and hence the initial commission of $2K should be capitalized and amortized over the 4 year period. At the time of renewal, $1K of renewal commission to be capitalized again over next 2 years.
- 17. ASC 606 and IFRS 15: The Impact on Sales Compensation Application for Sales Commission Amortization 2 Step Process be in synch with Revenue recognition schedule 1. For each Performance Obligation, determine the Commission cost (just like Revenue) 2. Amortize commission using the same schedule as revenue recognition
- 18. Bringing it all together for Sales Commission : Example (contd..) ABC Inc sells Software. A customer buys the software with 2 year support and annual upgrade for bundled price of $50K. Commission is earned as 10% of Total Contract Value at the time of contract signing. How should the commission be capitalized under ASC 606? Step 5: Recognize Revenue (Recap) At Contract signature: $35 K (Software) At the end of Year 1: $10 K (Upgrade) At the end of Year 1: $2.5K (support) At the end of Year 2 $2.5K (support) -------------- $50 K ASC 606 and IFRS 15: The Impact on Sales Compensation Step 1: Determine Commission for each Obligation Software: 10% of $35K = $3500 Upgrade: 10% of 10K = $1000 Support: 10% of $5K = $ 500 Total : 10% of $50K= $5000 Step 2: Recognize Commission Costs Amortization schedule should be in synch with Revenue recognition schedule At Contract signature: $3500 (for Software) At the end of Year 1: $1000 (for Upgrade) At the end of Year 1: $ 250 (for support – 50%) At the end of Year 2 $ 250 (for support – 50%) -------------- Total: $5000
- 19. ASC 606 and IFRS 15: The Impact on Sales Compensation Implementation Challenges Need to calculate commission for each individual Contract If Contract has multiple Performance Obligations, need to calculate commission for each obligation Attainment based tiered commission rates make it difficult Returns / Cancellations Employee Terminations
- 20. ASC 606 and IFRS 15: The Impact on Sales Compensation Why spreadsheets will fail you? Spreadsheets can’t provide the end-to-end visibility to capture the right data needed to comply with the new standard. Companies need to be ready to: Track the direct and incremental costs for each revenue contract Define and document their amortization strategy Determine the amortization period and record the amortization expense over that term To Comply, Companies need to ask: Can You Access the Right Data? How Will You Determine and Manage the Amortization? What is your Sales Compensation Strategy?
- 21. ASC 606 and IFRS 15: The Impact on Sales Compensation How can the right Sales Performance Management (SPM) system help? • Calculate the commission per individual contract as per the accounting policies • Differentiate between single & multi-year contracts • Capture appropriate data points of transactions, commission pay-outs & account expenses • Differentiate between commissions for supervisors and direct sales commissions • Adapt to frequent changes in the contract and enable seamless accounting across them
- 22. ASC 606 and IFRS 15: The Impact on Sales Compensation What should you look for in the SPM tool • Generation of the Necessary Data for Capitalization • Integration with CRM, CLM, and CPQ systems –. • Flexible Reporting • Automation of Data into ERP or Revenue Management Systems –
- 23. ASC 606 and IFRS 15: The Impact on Sales Compensation Other Resources Accounting for Sales Compensation becomes even more challenging under ASC 606 and IFRS 15 Download Finance and Sales Leaders: New Revenue Recognition Rules Bring Changes for Sales Commission Accounting Download
- 24. ASC 606 and IFRS 15: The Impact on Sales Compensation http://spectrumtek.com/ SPM Consulting Optimize Your Technology, Processes and Plan Design SPM Platform Selection Evaluating and Selecting SPM Tool Per Your Needs SPM Implementation Proven Expertise in Large Global Implementations Managed Services End-to-end Administration of Commission Operations </>
Editor's Notes
- Commission Administrators need to understand the spirit of ASC 606, so they can provide the right information to the accounting team. Accountants need to understand how SPM works
- There are two organizations behind ASC 606 FASB develops Financial reporting standards. Commonly known as GAAP for US based companies IASB develops accounting standards for International Financial Reporting Standards known as – IFRS. IFRS is adopted in many parts of the world, including the European Union but not in the US. IFRS 15 specifies how and when to recognise revenue from customer contracts. ASC 606 is IFRS 15 equivalent for US companies. It provides a principles based five-step model to be applied to all contracts with customers. The full name of the rule is ASC 606: Revenue from Contracts with Customers.
- Two Problems : Guidelines on how to report revenue from contracts with customers were not clear. Different companies were reporting differently, making it very difficult for analysts and shareholders to compare the numbers of two companies Companies in US following GAAP, were adopting different practices from non US companies following IFRS As more and more industries are offering their goods and services via subscription contracts, it was becoming more and more important to put some common standards around how to recognize subscription revenue. The goal was to simplify and standardize revenue recognition practices. So in 2014, FASB) and IASB got together and issued new standards for recognizing revenue from contracts with customers. FASB and the IASB formed the Joint Transition Resource Group (TRG). TRG members include industry professionals from a range of industries and geographies. TRG comments are not authoritative, but they do provide the community with insight on applying ASC 606 Timelines
- ASC 606 has provided detailed specific examples on how to handle revenue recognition. Accounting professionals can read TRG papers and figure out what is to be done. But for recognizing costs, especially Commission costs, ASC doesn’t address various type of commission programs. As we know, sales compensation programs vary a lot from industry to industry, and within the industry from company to company. So the problem of ASC 606 is particularly hard for sales compensation. GAAP is complex but it is somewhat scientific. It doesn’t require accountants to apply lot of judgement. Just follow the rules. ASC 606 on the other hand, is a move towards principles-based standards Accountants have to understand the spirit and core principles of ASC 606 and apply the judgement And for it to work for Sales Compensation, Accountants need to understand Sales Compensation Programs and Commissions team has to understand the core principles of ASC 606 Together they have to figure out whether sales compensation should be capitalized or not. We are working with several clients in enhancing their SPM tools, mostly building new reports for ASC 606. And in every single case, we see commissions manager and Accountants both on the table. Lot of collaboration is needed for company to correctly figure out how to handle ASC 606 for Sales Compensation.
- That’s too big a sentence for my taste. In simply words, it means two things: a. Just because customer has accepted the invoice, it doesn’t mean that revenue can be recognized. b. Revenue should be recognized as and when the customer actually receives the promised goods or services. For example if a customer signs up for a 2 year subscription, the revenue should be recognized over 2 year period. ASC 606 prescribes a 5 step approach to recognize revenue. We’d discuss that in a bit.
- The core principle of ASC 606 is a 5 step model for revenue recognition. And the same model has to be applied to costs as well. So it is important to have a high level understanding of what this 5 step model is all about. Each of these 5 steps, have several implications, some of which is consistent with what GAAP says, while others are somewhat new. Each of these 5 steps is a topic in itself, requiring hours of discussions. This webinar is about Sales Compensation, so I’ll discuss the 5 step model at a very high level and quickly dive into Sales Compensation aspects of it. Step 1 – Identify the contract. Remember it is all about recognizing revenue from contracts with customers. To figure how to recognize the revenue or cost, one has to first clearly define the Contract, and what all is included. If several small contracts have lots of dependencies, and have a single commercial objective, then may be these need to be considered as single Contract for ASC 606 Step 2 – Identify Performant Obligation in the contract. What is a Performance Obligation? Simply speaking, every item in the Contract that is distinct in nature, and provides some distinct value to the customer should be identified as a separate PO. It is important to do so, because each PO has to have its own revenue recognition. Step 3- Determine Transaction Price. Normally it is very simple. It’s just the money that the customer will pay as part of this contract. But in some cases, it can be bit complicated due to taxes, penalty clauses, interest charges and if there is some kind of non cash payments. Step 4 –Allocate the transaction price to each PO. This is the step that can get complicated and require some judgement. If the contract has multiple items sold together under one contract, ASSC 606 requires that each item has to be allocated a portion of Transaction Price. So we have to take the total TP and applying business judgement, allocate it to various items included in the contract. Step 5 – Recognize the revenue as each PO is delivered as per the Transaction Price allocated to it. Let me take an example to demonstrate this 5 step approach.
- ABC Inc…. Under GAAP, it is perfectly OK for company to recognize the entire revenue of $50K right away, and most companies do exactly that. But come 2018, these companies have to do something different. They would have to follow 5 step approach. Step 1 – Contract. That’s simple, so I am not going to spend much time on it. Step 2 – Now they need to identify what all is included in this one 50K contract. In other words, what are the various PO in this contract that the company has to deliver. - Software to be delivered at the time of purchase - New version of the Software – at the end of Year 1 - Customer support for Year 1 and again for Year 2 Step 3 – Now we have to identify what’s the Transaction Price for the contract, which in our simple example is pretty obvious to be $50K. Step 4 – Now comes the complicated part. We have to allocate the txn price to each Obligation in the contract. There are 3 items in this bundle, all together priced at $50K. But since each of these items is a distinct PO, we have to allocate the txn price to each item separately. How do we that? - We need to figure out what % of the bundle price should be assigned to each item. Discuss VSOE - One way to do this would be to figure out FMV of each item. Ie the price customer would have paid, if these items were sold individually - Let’s say FMV for software package is $70, value of new version is $20K and company sells annual support for $5K per year - So if sold without bundle discount, the transaction price would have been $100K. - Software would have been 70% of that, Upgrade would be 20% of it, and Support would have been 10% - Now that we know % of each item in the bundle, and we also know the transaction price for the bundle, we can now allocate the price to each Obligation - So 70% of 50K, ie 35K for software, 20% of 50K ie 10K for Upgrade and 10% of 50K ie 5K for support Step 5 – Now we have 3 obligations in the contract, to be fulfilled over two years, and we know the allocated price for each obligation. As these obligations are fulfilled, the revenue should be recognized.
- Question # 1 – Just like your example, we sell software package, but we don’t charge separately for upgrades. As long as customer is paying support, they get free upgrades. How does it change our revenue recognition, compared to your example? Ans – in that case, there would be just two PO – Software and Support. If customer is not paying for upgrade, and there is no implied expectation that company has to deliver an upgrade, then it is not a PO. And if it is not a PO, you can’t assign any transaction price to it, or associate any revenue to it. After answering the question, MG reviews the agenda. ASC 606 is the buzz word, and everyone talks about it, and it provides detail guidelines about how to recognize revenue from customer contracts. Now sales compensation is not a revenue, it is a cost. So we have to focus on a sub topic within 606 that talks about how to recognize the costs in obtaining a customer contract.
- ASC 340 says that any cost related to obtaining a contract should be capitalized, If it is Recoverable and Incremental. Recoverable meaning that customer would pay for it Incremental meaning it is incurred, only if the contract is signed. The opposite is also true. If the cost is NOT incremental, it should NOT be capitalized. Sales commission of course meets both these criterion, and hence we need to understand ASC 340 guideline It is important to understand this concept of recoverable, and incremental, so let’s see a few examples:
- Costs such as legal costs in drafting the contract, travel fee and salaries for sales team -These costs are incurred even if the contract is not signed. So these do not qualify as Incremental costs, and can NOT be capitalized and should be expensed as they are incurred. Sales Commission, however, is incremental coz it is paid only if the contract is signed, and it is expected that customer will pay to recover these costs. So it meets both the criterion and must be capitalized. For your internal cost accounting purposes you can attribute legal costs, travel costs to this customer, but when it comes for ASC 606 reporting, you can’t capitalize these costs.
- Now I’d like to talk about a very important clause within ASC 606 – it’s called Practical Expedient clause. It says, that Costs of obtaining a contract can be expensed right away, if the amortization period is one year or less. It is important because it gives the option – even if the cost is incremental and recoverable, if the duration of the contract is one year or less, the commission costs can be expensed right away. Some of our clients, who don’t offer warranties beyond 1 year, are opting for this clause, and they can avoid all the complication about capitalizing the commission costs. One thing to note here is that if you chose to take this option, you have to be consistent in applying it. All contracts with one year or less, must be expensed right away. You can’t pick and chose which contract to capitalize and which to expense. For example if a company sells computers, and it sells 1 year warranty with it. The warranty is never more than 1 year. In that case, company has the option to go for this clause and entire revenue, including the one that they are getting for Warranty can be expensed at the time of Sale. After the slide is done Question # 2 – We are a SaaS company, and almost always our customers signup for 1 year agreement, and renew at the year end. Can we use Practical expedient clause and avoid ASC 606? Ans 2 – If the customer has the option to renew, and you do expect the customer to renew, then it becomes more complicated. We have to take into account the expected life of the contract. I’ll discuss this in more detail in a little bit, just hang on to this question.. Question # 3 – What about various marketing costs, such as advertising costs. We are currently expensing those when incurred. Does ASC 606 require us to capitalize those? Ans - NO
- Read the first line. Currently, many companies, don’t put commission as a cost on the books, unless it is due for payment. But in ASC 606 world that’s not acceptable. Per TRG.. Explain example As for amortization of $2K is concerned, company has to have a policy on how to amortize it. It can be amortized on quarterly basis, or annual basis. Whatever the accounting policy is, it has to be applied consistently across all contracts. Again, the timing of commission payment doesn’t matter. If you pay commission for a new customer contract, the cost must be capitalized at the time of contract signature, and amortized over the duration of the contract.
- Read the situation. There are two points to consider – Do you pay additional commission when the contract is renewed, and how much? If you don’t pay additional commission, what is the expected life of the contract. It is important to understand this concept of expected life of the contract. So based upon whatever you know about this customer, and your track record with similar customer, you have to take a judgment call, and figure out how long is this customer going to stay with you. Whatever that period is, the commission cost has to be expensed over that period. Just to recap- if there is a very high probability of customer renewing the contract, and you do not pay additional commission at the time of renewal, you have to estimate the expected life of the contract, and amortize the initial commission over that period.
- I have 3 different situations here. In Case # 1 – company pays no commission at renewal, and expects customer to stay on for 4 year. If that’s the case $2K has to be amortized over 4 years. In case # 2 – company pays additional 4 %, and expects the customer to stay on for 4 years. In that case, since commission is …. In case # 3 – company pays 2% commission at the time of renewal, and it expects this customer to stay on for 4 years. Now in this case… SO far we have been talking about theory and rules around ASC 606 and ASC 340. Let’s now talk about what we have to do to capitalize the commission. What does the process look like?
- Commission amortization is a two step process. Step 1 – If you remember, in step 4 of the 5 step model, we calculated the transaction price for each Performance Obligation in the contract. Similarly, now we have to determine the commission cost for each Performance Obligation Step 2 – For each Performance Obligation, as the revenue is being recognized, we have to also recognize the costs. The schedule for commission amortization has to match the schedule for revenue recognition. Now I’ll go back to the example we used when we discussed 5 step model. We already saw how the company will recognize the revenue. Now we’d discuss the commission plan for this company, and discus how to handle the commission costs. How much to capitalize, and when to amortize?
- After MG stops talking on this slide.. Question 4 – We have similar business model as you mentioned, but for customer support, we invoice customer only when the next year begins. So even if customer contracted for 2 year support, the invoice for Year 2 support would be sent at the end of Year 1. Do we still have to capitalize entire commission at the beginning? Ans – It depends upon how your commission plan is defined. If commission is earned at the time of booking the contract, then the timing of commission payment or customer invoice doesn’t matter. And entire commission has to be capitalized when the contract is signed. If your compensation plan says that commission is earned when customer is invoiced, then, yes you don’t have to capitalize the commission for Year 2 support until invoice is sent out.
- MG to talk and then Kevin to ask the question, and answer this Q# 5 – Does IBM or any other SPM tool has a built-in module for ASC 606?
- Spectrum Technologies is a technology and business consulting firm specializing in the field of Sales Perf Management. We are headquartered here in Silicon Valley, our HQ is in Sunnyvale, CA near San Francisco. We also have offices in Seattle in Washington and in Mumbai, India. Four practice areas We have been around for almost 10 years now. We have a team of 45 professionals spread here in US and India.