Deferred Commissions Accounting Under ASC 606

When a company pays its sales team a commission for securing a new customer contract, the accounting for that payment is not always a simple expense. Instead, these payments, known as deferred commissions, are often treated as an asset. This approach spreads the cost over the contract’s duration, aligning the expense with the revenue it helps to generate. This method provides a more transparent view of a company’s financial health, particularly for businesses with long-term customer agreements.

Identifying Commission Costs for Deferral

The principle for deferring commissions is identifying which costs qualify. Accounting Standard Codification (ASC) 606 states that only the incremental costs of obtaining a contract should be capitalized. An incremental cost is one the company would not have incurred if the contract had not been obtained.

A clear example of an incremental cost is a sales bonus paid for signing a new client, as the company would not pay it if the deal did not close. Conversely, a salesperson’s regular base salary does not qualify for deferral because it is paid regardless of whether a specific contract is signed. Costs from broad marketing campaigns or general legal fees are also not deferred as they are not tied to a specific contract.

This analysis requires companies to carefully examine their compensation plans and related expenses to isolate only those costs that are truly incremental. For instance, fringe benefits associated with a direct commission payment, such as payroll taxes, may also be considered incremental and eligible for deferral. The key is the direct link between the cost and the successful execution of the contract.

ASC 606 also includes a practical expedient for companies to simplify this process. If the amortization period for a commission is one year or less, the company can choose to expense the commission cost as it is incurred. This option allows businesses to avoid the complexity of capitalizing and amortizing short-term costs, though it must be applied consistently to similar types of contracts.

Initial Recognition and Measurement of the Asset

Once incremental costs are identified, they are not immediately expensed. Instead, these costs are capitalized, meaning they are recorded as an asset on the balance sheet. This asset represents the future economic benefit from the cost incurred and is often titled “Deferred Commissions” or “Contract Cost Asset.”

The asset is recorded with a journal entry. The company debits the Deferred Commission Asset account and credits either Cash or Commissions Payable. A credit to Cash is used if the commission has been paid, while Commissions Payable is used if the company owes the commission but has not yet paid it.

To illustrate, imagine a software company signs a three-year subscription contract with a new customer. The salesperson who secured the deal earns a $6,000 commission, which is determined to be an incremental cost. At the time the contract is signed, the company would make the following journal entry: a debit of $6,000 to Deferred Commission Asset and a credit of $6,000 to Commissions Payable. This entry increases the company’s assets by $6,000 and its liabilities by the same amount until the commission is paid.

The initial measurement is based on the actual cost incurred. The value of the asset is the total of all identified incremental costs for that contract. This process shifts the commission from an immediate income statement expense to a balance sheet item that will be methodically expensed over time, better aligning with the revenue generated from the contract.

Amortization of Deferred Commissions

After capitalizing the commission, the next step is to systematically expense it over time through amortization. The principle is to match the commission expense with the revenue generated by the contract. This means the asset is reduced as an expense is recognized on the income statement each period the company recognizes revenue.

Determining the correct amortization period is an important judgment. The period should reflect the time during which the company expects to benefit from the costs incurred. At a minimum, this is the initial contract term. However, ASC 606 requires companies to also consider anticipated contract renewals or extensions if there is an expectation that the customer relationship will continue. For example, if a two-year contract is highly likely to be renewed for an additional two years, the amortization period should be four years.

The journal entry for amortization is a debit to Commission Expense and a credit to the Deferred Commission Asset. This entry moves a portion of the asset’s cost to the income statement. Using the previous example of a $6,000 commission on a three-year contract, the annual amortization expense would be $2,000. Each year, the company would record this entry for $2,000.

If a customer contract is terminated before the end of the amortization period, the accounting must be adjusted. Any remaining balance in the Deferred Commission Asset for that contract is written off. This means the entire remaining value is recognized as a commission expense in the period the contract is terminated.

Financial Statement Presentation and Disclosures

On the balance sheet, the deferred commission asset is classified as a non-current asset because its benefits are realized over more than one year. The portion of the asset that will be amortized within the next 12 months is reclassified as a current asset.

On the income statement, the amortized portion of the commissions is recognized as Commission Expense. This expense is included within the Selling, General, and Administrative (SG&A) expenses category.

ASC 606 mandates specific disclosures in the notes to the financial statements. Companies must disclose:

• The judgments used to determine the amount of costs capitalized, particularly how they identified which costs were incremental.
• The method used for amortization, such as the straight-line method over the contract term.
• The closing balances of the deferred commission assets at the beginning and end of the reporting period.
• The total amount of amortization recognized as an expense during the period.