After a full year of partnering with numerous tech companies to implement the new revenue recognition standard, Accounting Standards Update (ASU) 2014-09, Revenue from Contracts with Customers (ASC 606), it has become clear that one of the largest impacts was not necessarily on when or how revenue was recognized, but rather on the accounting for costs to obtain a contract, which was included in the new guidance as part of Subtopic 340-40, Other Assets and Deferred Costs – Contracts with Customers, which was created by ASU 2014-09. The most significant cost to obtaining a contract for tech companies is typically commissions. Since tech companies heavily rely on commissions to incentivize their sales team and acquire customers, it is imperative to understand the impact that the standard can have on the Company’s financial statements.
Capitalize or Expense?
Prior to the adoption of ASC 606/340-40, sales commissions were generally expensed as incurred. Under the new guidance, certain sales commissions that are incremental and recoverable are now required to be capitalized and amortized. In other words, if the commissions would only be incurred if a contract is executed and is expected to be recovered from future cash flows generated directly from the contract, then they meet the capitalization standard.
Given that sales commissions come in many flavors; those based on annual contract value, total contract value, renewals, and to a lesser extent, top-level bookings or revenue, determining which commissions are required to be capitalized can be a headache. If the amortization period is less than one year, companies may elect a practical expedient to continue to expense the commissions in the period incurred, as is consistent with the legacy standard.
In our experience, the practical expedient (where the expected customer life is less than one year) is rarely utilized in the SaaS industry since subscriptions are frequently renewed, and the focus lately has been on multi-year deals. Since the amortization period is the expected customer life, it does include assessing any anticipated renewals. Other factors to consider in determining the amortization period include customer churn, the length of time the company expects the software to be relevant before significant enhancements or new versions are expected, and comparable market data for renewal rates. As such, the amortization period is a significant estimate that requires review of historical data, when available, and can be challenging for companies to develop a method to reasonably estimate the useful life.
I wouldn’t be an accountant if I didn’t tell you that the application of this guidance is very nuanced. The standard’s not-so-crystal-clear guidance leaves a lot of room for questions, subjective estimates, and professional judgment, which has been particularly difficult for earlier-stage companies without years of historical data or with new products, to make solid estimates or without the tools in place to capture and track that data.
Are you a technology sector company looking for some guidance in adopting ASC 606/340-40 or accounting for sales commissions? If so, please reach out to Catherine Saadat, a Director in Aronson’s Technology Industry Services Group today.