ASC 606, a revenue recognition standard created by the Financial Accounting Standards Board, changed the way SaaS companies recorded expenses related to sales commissions. Instead of recording sales commissions as an expense immediately, startups now have to record the sales commissions throughout the life of the contract. So if your sales rep sold a customer a two-year subscription to your SaaS platform, the commission for that sale would also be recorded over a two-year period.
The Matching Principle and Sales Commissions
Accrual accounting depends on the matching principle. Under this principle, you record expenses as your business incurs them. You also record revenue as your business earns it by providing services. This is an alternative to cash-basis accounting where you record costs and revenue immediately. The ASC 606 rule is based on the matching principle.
For example, if you convinced a company to sign a two-year contract for a service that cost $200,000, you would record the revenue you earned from the contract this year as $100,000 under accrual accounting. You wouldn’t record the entire $200,000 as revenue this year because half of it will come from services that your company will provide next year. You would make a second journal entry to record the additional $100,000 in revenue next year.
ASC 606 applies the same concept to the expenses related to that contract, and these expenses include sales commissions. So if you paid the sales representative a $10,000 commission for winning that contract, instead of recording a $10,000 expense this year, you would record an expense of $5,000 this year and an expense of $5,000 next year.
Setting Up a Commissions Payable Account
You’d still pay the sales representative a commission of $10,000 on this deal, and the matching principle requires matching this expense to an asset. This asset is called commissions payable and it’s a new general ledger account. You can then amortize commissions payable over the same period in which your company earns revenue from the contract. SaaS contracts typically include monthly fees, so you would amortize a portion of the contract each month.
This is how the amortization process works for commissions, using the numbers from the previous example. After you paid the $10,000 commission to the sales rep, you would add a $10,000 entry to the commissions payable account. Then, each month, you would credit commissions payable for that month’s portion of the contract and debit commissions expense. For a two-year contract, that means that each month you would credit commissions payable for $10,000 / 24, or $416.67, and then record a commissions expense of $416.67.
If the contract lasted for five years instead, that’s a period of 60 months, so you would amortize 1/60 of the sales commission each month. You would still debit commissions payable for $10,000 at the beginning of the contract, but each month you would credit the account by $10,000 / 60, or $166.67. Then, you would record a commissions expense of $166.67 for that month.
This amortization process applies to every individual contract that a SaaS provider has signed with a customer that has a duration longer than a year. You will have to make the correct entries to commissions payable and commissions expense for each contract every month. Accounting automation software can handle this process and track the contracts for you, though.
Selecting an Appropriate Amortization Period
Many SaaS contracts don’t have a fixed duration, so it’s not always clear how long the amortization period for a contract should be. The CPA firm Aronson LLC explains that when a company estimates the duration of the SaaS contract it should consider renewals and churn. If a SaaS contract lasts for two years but most companies will renew it at that point, for example, then the company could consider using a four-year amortization period. Even though the contract has an official length of two years, using a four-year period would produce more accurate financial projections.
And if the average customer stops using the SaaS after six months, then the expected duration of the contract is six months and the company doesn’t have to worry about the complicated amortization process at all. It’s not necessary to amortize sales commission expenses under ASC 606 if the SaaS contract lasts for less than a year.
Conclusion
ASC 606 might seem confusing, but this rule makes a SaaS company’s financial statements more accurate. Under the matching principle, if a SaaS provider expects to receive a fee from a customer once per month for the next four years, then it makes sense to apply the commission fee to each monthly payment rather than recording the entire commission as an expense in the first year. Otherwise, it would look like the SaaS company paid out very high commissions in the first year of the contract and then didn’t have to pay out any commissions during the next three years.