Does ASC 606 apply to all contracts?
FASB ASC 606 applies to public, private, and not-for-profit entities that enter into contracts with customers to transfer goods and services. However, contracts that are covered by other standards — notably leases, insurance contracts, and certain financial instruments — are not subject to the new standards.
What is Subtopic 340-40?
The FASB added Subtopic 340-40 to provide accounting guidance for certain costs related to a contract with a customer within the scope of ASC 606. In particular, Subtopic 340-40 pertains to the incremental costs of obtaining a contract with a customer and costs incurred in fulfilling a contract with a customer, if those costs are not in the scope of another topic. Iconixx customers will be most concerned with the incremental costs of obtaining a contract, which include sales commissions.
Under existing accounting standards (ASC 605), companies can treat sales commission costs as a period expense or they can capitalize them and amortize the expense over the contract period. Under ASC 606 and Subtopic 340-40, the “incremental costs of obtaining a contract with a customer” are to be capitalized as an asset if the company expects to recover those costs.
How does a company determine the amortization period?
Subtopic 340-40 says, "An asset recognized in accordance with the incremental costs of obtaining a contract (Para 340-40-25-1) shall be amortized on a systematic basis that is consistent with the transfer to the customer of the goods or services to which the asset relates."
In some cases, this can mean that the capitalized commissions are amortized evenly over the initial term of the contract. This would be the case if the initial contract was for 3 years and at the end of the term the customer renewed for 2 more years, and the commission rate on the renewal was commensurate with the commission rate on the initial term. However, if the commission rate on renewals is much lower than for the initial contract, the company might determine that the initial sales commission actually applies to the entire term (initial and renewal terms) and amortize the initial commission over 5 years.
Are the incremental costs to obtain the contract capitalized if the contract has termination proviious that allows cancellation without consideration or penalty
If a multi-year contract has a termination provision that allows one of the parties to terminate without substantive consideration or penalty, this may indicate what is effectively a month-to-month contract — which would require recognizing revenue monthly, regardless of the stated contractual term. On the other hand, if substantive termination penalties are in the contract, that is evidence for the stated term. Members of the Joint Transition Resource Group (TRG) said that companies will need to assess whether termination provisions and notification periods for cancellation are substantive.
Should fringe benefits on commission payments be included in the capitalized amounts?
The Joint Transition Resource Group commented that fringe benefits should be capitalized as part of the incremental cost of obtaining a contract if the additional fringe benefit costs are based on the amount of commissions paid and the commissions qualify as costs to obtain a contract (e.g. employer portion of payroll taxes, 401-K matches). However, for fringe benefits where the costs would have been incurred regardless of whether the contract had been obtained (e.g., health insurance premiums), the fringe benefits should not be capitalized.
What about commissions or bonuses for sales managers and sales engineers?
If a sales manager or sales engineer commission is linked directly to the individual sale, then it is capitalized in the same manner as the sales representative's commission. If they are paid a commission on aggregate sales performance of a team, this would be a judgment call by the company and its accounting team. A bonus paid to sales managers based on achieving sales targets combined with an overall profitability level would be a period expense and not capitalized.
I've heard that ASC 606 requires more disclosure for users of financial statements. Is this also true for contract costs coverd by Subtopic 340-40?
Yes, Paragraph 340-40-50-1 requires disclosures of assets recognized from individual contract costs. Companies are required to disclose the closing balances of assets recognized from incremental costs to obtain a contract, the amount of amortization and any impairment losses recognized in the reporting period. Companies must describe the judgments they made in determining the amount of the costs incurred to obtain or fulfill a customer contract. The method used to determine the amortization for each reporting period also must be described. The standard provides an exception for nonpublic entities, permitting them to choose to provide all of the disclosures required for public entities or to provide reduced disclosures.
Will companies be required to restate prior years financials under ASC 606 guidance?
ASC 606 requires retrospective comparisons of financial statements, with the new standards applied to previous years’ statements. FASB allows two methods, full or modified retrospective. Under the full retrospective method, ASC 606 is applied retrospectively to each reporting period presented in the financial statements. To ease the transition burden, three practical expedients are provided for the full retrospective method.
Under the modified retrospective method, a company recognizes the cumulative effect of ASC 606 on the reporting periods shown on the financial statements and makes an adjustment of that amount to retained earnings at the beginning of the first year of ASC 606 application. There are some additional disclosure requirements when the modified retrospective method is used.
What are some of the key system requirements to support the changes to sales compensation accounting?
Under ASC 606 and Subtopic 340-40, it is important to have timely, accurate, auditable compensation calculations, reportable and updatable, for each individual contract that has deferred revenue generated. Sales compensation management (SCM) software provides accurate calculations of variable compensation and can (and should) calculate and report this compensation for each individual contract. These calculations may change over time with the existence of accelerators and other variables, and the system accurately maintains these calculations to allow contract-specific compensation to be recorded.
The sales compensation management system’s reporting capabilities should support the accountant’s need for auditable data for disclosure tables, impairment testing, and preparing amortization schedules. The level of detail available from an SCM database will help facilitate auditable accounting for costs of modified contracts.
Last, detailed compensation cost data can help greatly with determining the profitability of a contract, as well as forecasting financial statements.
Iconixx SalesTM has the ability to handle the most complex sales compensation structures, and the flexibility to adapt as interpretations and guidance for ASC 606 and Subtopic 340-40 continue to evolve.