Accounting for Capitalized Commissions Under ASC 606

The Financial Accounting Standards Board’s (FASB) issuance of Accounting Standards Codification (ASC) 606, Revenue from Contracts with Customers, established a comprehensive framework for revenue recognition. A significant aspect of this standard involves the accounting for costs incurred to obtain a contract, which are governed by ASC 340-40, Other Assets and Deferred Costs—Contracts with Customers. This guidance changed how companies treat certain expenditures, particularly sales commissions. Previously, many such costs were expensed as they were incurred. The standard now requires certain costs to be capitalized as an asset and amortized over time.

Identifying Incremental Costs to Obtain a Contract

The core principle of ASC 340-40 is the capitalization of “incremental costs of obtaining a contract.” These are defined as costs that a company would not have incurred if the contract had not been obtained. The guidance requires a direct cause-and-effect relationship between securing the contract and incurring the cost. If the cost would have been paid out regardless of the contract’s outcome, it cannot be capitalized and must be recognized as an expense.

A sales commission paid to an employee or an external agent that is contingent upon a customer signing a contract is an incremental cost. For instance, if a salesperson earns a $5,000 commission only when a specific client contract is executed, that $5,000 is an incremental cost. This applies even if commissions are paid to multiple individuals for the same contract, such as a salesperson, their manager, and a regional director, provided each payment is contingent on that specific sale.

Conversely, many sales-related costs do not meet the “incremental” threshold and must be expensed as incurred. The fixed salary of a salesperson is not an incremental cost because it is paid regardless of whether any particular contract is won. General marketing and advertising expenses, costs to prepare a proposal or bid, and travel expenses for a sales pitch are also not incremental.

A company must also expect to recover the capitalized costs. This recovery is assumed if the fees from the customer are sufficient to cover the costs.

Determining the Amortization Period

The guiding principle under the standard is that the asset should be amortized on a systematic basis consistent with the pattern of transfer of the goods or services to the customer to which the asset relates. In simpler terms, the expense should be recognized over the period that the company is satisfying its performance obligations and earning the related revenue.

For a non-cancellable two-year service contract, the amortization period is two years, and the capitalized commission would be expensed evenly over that period. The determination can become more complex when contracts include renewal options. If a company pays a commission on an initial contract and anticipates that the customer will renew, the amortization period may extend beyond the initial contract term. Management must use judgment to estimate the expected customer life, considering factors like technology, customer-specific assets, and historical renewal data.

The standard provides a practical expedient to simplify this process for many businesses. A company may elect to recognize the incremental costs of obtaining a contract as an expense when they are incurred if the amortization period of the asset would have been one year or less. For example, if a company pays a commission on a 12-month contract, it can choose to expense that commission immediately instead of capitalizing it and amortizing it over the next year. If a company chooses to use this practical expedient, it must disclose this accounting policy in its financial statement footnotes.

Accounting Treatment and Financial Reporting

The company records an asset, often titled “Capitalized Contract Costs” or “Deferred Contract Acquisition Costs,” and a corresponding liability or cash payment. For example, if a company incurs a $12,000 commission liability for a new three-year contract, the initial journal entry would be a debit to Capitalized Contract Costs for $12,000 and a credit to Commissions Payable for $12,000.

Following the initial capitalization, the company must periodically recognize a portion of the asset as an expense through amortization. Using the previous example, the $12,000 asset would be amortized over the three-year contract term. On a monthly basis, the company would record an amortization expense of $333.33 ($12,000 / 36 months). The journal entry for this would be a debit to Amortization Expense and a credit to Capitalized Contract Costs.

On the financial statements, the unamortized balance of the capitalized costs appears on the balance sheet. It is classified as a non-current asset, though the portion expected to be amortized within the next 12 months may be shown as a current asset. The amortization expense is reported on the income statement within the Selling, General, and Administrative (SG&A) expenses section.

Finally, companies are required to assess the capitalized contract cost asset for impairment. This means that if circumstances change and the carrying amount of the asset is no longer expected to be recoverable, the company must write down the value of the asset and recognize an impairment loss.