USA Accounting for Sales Commissions

[Edgar Mellencamp]

I am concerned that my client is taking the incorrect approach to accounting for Employee Sales Commissions. My understanding is that GAAP requires immediate expensing of sales commissions, as they are paid to employees and the employees have the right to receive them.

However, my client takes a different approach. They run a fairly traditional job costing shop, and sometimes it takes more than a month for a job to complete, and it is when the job has completed that sales revenue is recognized. However, instead of recognizing sales commissions as they are paid, they defer the recognition to the period when the job has completed and the sales revenue has been recorded, effectively carrying the payment of the commission on the job (which is fully paid before the job has completed) on their balance sheet as a prepaid asset. So essentially, if Salesman A sells Job 1 in March but Job 1 doesn't finish until May, the sales commission Salesman A earns on Job 1 is paid in March but not expensed until May.

A case could be made that their approach allows for better matching, since the sales commission expenses are matched with their associated revenue, but I would argue that it violates conservatism, since there is no assurance that the revenue will in fact be earned due to the customer option to cancel the job as it is in-progress, which they do with relative frequency.

If someone has any idea of the appropriate treatment or could direct me to the relevant guidance, I would certainly appreciate it! Let me know if I have described my issue clearly.

 

[kirby]

It is always the items that accountants consider to be "the basics" that are hard to explain to clients AND hard to find a specific rule for. So, there is no 'FASB statement" on this (at least that I know of). So, yes, conservatism then applies and says it is an expense right now.
You can try explaining it also this way. If the sales force was on salary and no commission, their salary is Admin Salaries Expense and not part of the product cost.
In any event, sales commission is not part of the cost to build that product.

 

[bklynboy]

I disagree with Kirby on this. Sales commissions are not like salaries since they only arise as an expense when a revenue producing event occurs. It is quite common to defer recognition of a sales expense to properly match it with the revenue or profits being produced. In fact, there is specific guidance in my area of selling life insurance where we pay a full commission day 1 but expense ratably with how premiums (revenue) or profits emerge. There are also clawback rules in place that would permit a company to recover a portion of the premium if the sales or revenue are not actually collected (not clear if this applies in the specific question asked).

The matching principle I believe is the correct way to think about this since the point of paying the commission is to obtain revenue. Until revenue is recorded, no expense should be recognized. This is quite common and is a superior way than using conservatism (which is reeally more about accounting for an item where there are more than 1 acceptable way of accounting and favors the one that has lower impact on assets or earnings).

Google "matching principle" so you can see why this makes more sense.

Also, the placement of paid commissions on the balance sheet is really a deferred asset and not a prepaid one (unless there is a forfeiture right if the sale does not materialize). Finally, the deferred asset should be tested for impairment as is any other asset so that it accurately reflects the connection to the sale (meaning if its apparent the sale will not occur and commission paid cannot be recovered then at that point its reclassed to expenses).

 

[kirby]

It is important to keep in mind that the industry Mr Mellenkamp's client is in is "traditional job costing" and not insurance. What is allowable GAAP in one industry does not fly in another. Which is why AICPA issues accounting guides by industry.
I think if we made a case for deferring sales commission in a job costing shop based on "matching" we should go whole hog and say that the related bonus to the CEO and Board should also be deferred "cause we are matching!"
So as all three of us lack a definitive cite of GAAP authority is this case, I think Mr. M. is on solid ground to look to conservatism, which says to expense it.

 

[bklynboy]

Kirby, there is definitive authority in GAAP. What is the point of the matching principle if not to ensure costs are matched to the period revenue is recognized? It is not a "specialized" accounting concept but standard across all companies. Your analogy to the CEO pay is not appropriate as my point was that the commission is directly tied to the sale and should follow together. Salaries are clearly earned over the service period and not recognized with sales.

Again, review the matching principle and tell me why this would not be the definitive guidance.

 

[Counterofbeans]

I don't agree with either of you.

Capitalizing solicitation costs, which include sales commissions, doesn't have to be, "part of the cost to build that product" in order to capitalize. Further, while the matching principle is a nice guideline to follow, it's often violated and isn't the only consideration, especially here where it's not relevant.

Kirby, there is definitive authority in GAAP.

Really?

Please provide specific guidance (note: it isn't the matching principle)


To the OP:

You asked a great question, as the answer depends...

The answer is a lengthy one, so I will do my best to summarize.

Solicitation costs include costs incurred by a vendor to solicit or acquire a specific customer or revenue stream. These costs exclude advertising costs. A sales commission is an example of a solicitation cost.

Limited guidance currently exists to address the accounting for these costs. Accordingly, the accounting for such costs must be based on the conceptual framework and analogies to the limited guidance that does exist.

Before these costs can be capitalized on the balance sheet, they must first result in something that meets the definition of an asset. And by the way, “Deferred Costs” in and of itself is not an asset.

In a nutshell, here is your answer:

You need to look at ASC 310 and ASC 605-20 & form an accounting policy that should be applied consistently and disclosed in the financial statements (it appears you will want to follow the model in ASC 605-20).

More specifically, the underlying principle in both of those is that there are certain costs of a revenue transaction that are so integral to the revenue generating activities that recognition of the costs in a period other than the one in which the related revenue is recognized is inappropriate. However, a policy election to analogize to non-refundable fees and other costs (a policy based on ASC 310) may result in a different amount of capitalized costs than a policy that analogizes to separately priced warranty contracts (that is, one based on ASC 605-20 policy).

ASC 310 specifically provides guidance for fees incurred to solicit and originate new loans. Under the ASC 310 model, origination costs directly related to a specific loan are eligible for capitalization. All other lending costs, including costs for advertising, soliciting potential borrowers, servicing existing loans, and other ancillary activities related to establishing and monitoring credit policies, supervision, and administration should be expensed as incurred.

On the other hand....

ASC 605-20-25 specifically provides guidance on accounting for costs associated with extended warranty and maintenance contracts. ASC 605-20-25-4 only allows for the capitalization of costs that are directly related to the acquisition of a contract that would not have been incurred had it not been for such acquisition. As a result, costs that would have been incurred regardless of whether a contract was obtained, such as salaries and benefits, generally cannot be capitalized. However, commissions paid to an employee based on obtaining a specific contract would be eligible for capitalization.

As such, and I stress that I do NOT know all the facts, but you can easily argue that the commission paid to an internal employee dedicated solely to selling activities would meet the capitalization requirements under ASC 605-20. These costs would be considered both direct and incremental, as the costs would not have been incurred absent the sale. However, the costs may not be capitalized by analogy to ASC 310, which permits only internal origination, and not solicitation, costs to be capitalized.

Also note that once capitalization of customer solicitation costs is deemed appropriate, which appears to be the case here, an assessment should be made as to the recoverability of such costs. This assessment should be made at the outset of the arrangement as part of the initial measurement of the amount of costs incurred that may be capitalized. Additionally, recoverability should be assessed on an ongoing basis (i.e., an ongoing impairment analysis should be performed).

Hope that helps

 

[bklynboy]

ASC 605-20-25-4 does apply to sales commissions as you rightly noted. The specific guidance is:

Costs that are directly related to the acquisition of a contract and that would have not been incurred but for the acquisition of that contract (incremental direct acquisition costs) shall be deferred and charged to expense in proportion to the revenue recognized. All other costs, such as costs of services performed under the contract, general and administrative expenses, advertising expenses, and costs associated with the negotiation of a contract that is not consummated, shall be charged to expense as incurred.

This is an example of the matching principle and should be the basis for determining when the expense is recognized.

I would not use ASC 310 which is specific to loans and not the type of transaction being discussed here.

 

[Counterofbeans]

I think you need to re-read my reply above, for I believe you are missing the point.

It's a company policy decision based on what standard you want to analogize to. This should be consistently followed and disclosed in the financial statements.

ASC 605-20-25-4 does apply to sales commissions as you rightly noted.

No, it doesn't. It relates to, "Separately Priced Extended Warranty and Product Maintenance Contracts." That isn't sales commissions. There is no direct guidance (aka limited guidance) on sales commissions, as I stated in my reply above.

This is an example of the matching principle and should be the basis for determining when the expense is recognized.

I simply don't understand this obsession with the matching principle. It's nothing more than a concept, perhaps an outdated concept, at this point. This isn't the '70s and '80s anymore. We have clearly moved to a model that bases revenue and expense recognition on asset and liability recognition and derecognition. I do agree that following the matching principle isn't necessarily going to result in bad accounting much of the time, but the exceptions are numerous.

Many believe that the matching principle is dead, including FASB board member, regulators, auditors & the SEC. The FASB and IASB members have indicated that matching principle has no impact on the way they analyze expense recognition decisions. What the Boards have realized from time to time is that assets and liabilities have been recognized in the past when expense recognition was motivated by the matching principle even though the definitions of assets and liabilities were not satisfied.

Carol Stacey, former chief accountant in the division of corporate finance, is a champion of this belief as well & teaches it frequently at various training seminars.

Granted, if someone follows the matching principle/conservatism, you're not likely to have an abundance of lawsuits or SEC enforcement actions; understating income just isn't a huge problem. But the matching principle just isn't a high priority anymore in the minds of FASB/SEC/auditors & most certainly shouldn't be the Bible when it comes to expense recognition.

I would not use ASC 310 which is specific to loans and not the type of transaction being discussed here.

Neither is warranty services, but analogizing to ASC 310 is just as as appropriate as analogizing to ASC 605-20. And note that they result in completely different expense recognition patterns when it comes to sales commissions.

It seems like the OP believes a model based on ASC 310 is more appropriate. Unfortunately, I'm not sure all of upper management is going to agree with that position, but it can be argued either way.

 

[bklynboy]

I will say that yes its a policy decision that each company separately evaluates but the favored treatment by PwC (who we use) when dealing with similar issues is to recognize the expense as revenue is recognized.

It is related to sales commissions - I pulled that exact reference off of the PwC interpretation of their guidance in the online research tool we have purchased from them (PwC Comperio). Exact wording is "ASC 605-20-25-4 does not make a distinction between costs that are paid to employees or to third parties, but focuses on the costs being direct and incremental. For example, the sales commission a vendor pays to its employees is eligible for deferral since the expense would not exist absent a particular contract." Again not a requirement nor official guidance but I believe the better practice here and more universally employed. I still believe ASC 605 is the better model compared to ASC 310 but yeah, it can be debated.

I don't want to debate this ad nauseum as I am in agreement with your overall response other than what I have experienced as preferred practice is to capitalize and recognize with revenue.

Regarding the matching principle - yes its not an end all if it distorts the financial information - nor have I ever claimed it was. It does have merit and is an important part of consideration when evaluating alternative acceptable accounting since it can lead to a better presentation of financial information.

 

[Gary Millin]

my question is we sell 2 types of contracts.
1. Set-up fee ($1000) (independent of the contract) + monthly $500 paid upfront for 12 months ($6K). We pay commission of 10% x the $7K collected upfront. so $700 in commission

contract term is 12 months. should we amortize commission over 12 months evenly (time based). or should we amortize it with the revenue. so $100 x ($1500 / $7000) in month 1 and the rest monthly for 11 months.


2. Set-up fee ($1000) (independent of the contract) + month to month deal $600 paid monthly.
In this case we pay commission of 10% x $1000 setup + we pay 10% on 6 months of commission so $3k x 10%. I know the monthly contracts last at least 5 months on average in the first 6 months. So I was going to amortize the full commission over the 5 months expected average term in the first 6 months. While there are multiple revenue streams I am amortizing based on contract term.

thoughts? suggestions?