Amortization in Commission Sales
Definition: For commission sales, amortization refers to the spreading out of the cost of paying commissions to salespeople over the period during which they produce revenues. This system of accounting relates the expense of sales commissions with the revenues that are produced through them, based on the principle that expenses need to be matched with the revenues they help to produce.
Key Concepts
Under the new revenue recognition standard ASC 606, companies are supposed to capitalize and then amortize commission expense over the expected period of benefit, thereby ensuring sales commissions are recognized in the same period as the revenue they assist in generating. The core stages in the process are:
- Capitalization: Initially, the total commission is capitalized as an asset on the balance sheet rather than appearing as an immediate expense on the income statement.
- Amortization: Next, the capitalized commission is amortized over the period the revenue related to the commission is recognized. This is spread over the expected service period by the commission.
Benefits of Amortization in Commission Sales
- Improves Matching: Amortizing commissions contributes to improving matching sales expenses with revenues, hence increasing the accuracy of the financial reports.
- Increases Predictability: Amortization provides a clearer view of future expenses, hence more accurate budgeting and forecasting.
- Compliance with ASC 606: The approach ensures the compliance of ASC 606 revenue recognition standard, in the case where the matching is required with sales commissions.
Real-World Example
A software company selling a $12,000 one-year subscription would recognize $1,200 of commission expense by paying a 10% sales commission. Instead of taking the full $1,200 commission in the first month as an expense, the company would capitalize this cost and then expense it ratably over the 12 months of the service period:
- Initial Capitalization: The $1,200 commission is put into the balance sheet as an asset.
- Monthly Amortization: $1,200 / 12 months = $100 a month. Each month, the expenses are recorded in the amount of $100, which conforms to the revenue of $1,000 from the subscription that has been recognized each month.
Detailed Explanation and Compliance
Under ASC 606, the sales commissions are considered incremental costs of obtaining a contract, and as such, these are to be capitalized and then amortized. Amortization shall be over the contract term or the period over which the expected benefit of the cost is to be realized, whichever is shorter, considering customer lifetime value, contract renewals, and product life cycles.
For example, a company that recognizes revenues based on a three-year customer relationship policy would have amortization on sales commissions spread over the period of three years. In this way, the financial statements would depict the earning process accurately.