Accounting for sales commissions involves many complexities, especially for companies with multi-tiered sales teams and complex commission structures.
Mastering sales commission accounting involves designing clear commission frameworks, addressing tax issues, and ensuring compliance with Generally Accepted Accounting Principles (GAAP). All of these demand a good understanding of accounting standards.
To add to this mix, ensuring compliance with the ASC 606 revenue recognition standard can complicate matters further.
The importance of accurate sales commission accounting
Accurate sales commission accounting is crucial for businesses to maintain transparency and ensure that commissions are calculated and paid correctly. This will, in turn, motivate the sales force and align their efforts with the company's goals.
Under the ASC 606 standard, businesses must track commission expenses in detail and create an audit trail that shows the contract term and how each commission benefits the company. Additionally, companies need to determine the appropriate duration to amortize the expense and understand the overall impact of all commissions paid. Many companies find it challenging to fully grasp these new regulations, making it essential to get a better understanding of the accounting standards and start the transition early.
In this blog, we’ll cover the key aspects of ASC 606, best practices for managing commission accounting, and tips to simplify the process for your organization.
Understanding sales commissions
Sales commissions are crucial for compensating your sales team and driving better performance. Commissions are typically calculated as a percentage of the sale price and can be paid on a monthly, quarterly, or annual basis.
Accounting for sales commissions includes several basic elements. Familiarizing yourself with these elements before you start will simplify the accounting process and allow you to make informed decisions.
Key elements of sales commission accounting:
- Commission plans: Define the structure and criteria for earning commissions—including rates, tiers, and thresholds.
- Amortization period: Establish the period over which to amortize commission expenses and align it with the contract duration.
- Deferred expenses: Understand how to handle commissions as deferred expenses until the related revenue is recognized.
- Recording sales commissions: Create journal entries to document commission expenses and liabilities for unpaid commissions.
- Timing of payments: Decide when sales reps will receive commission payments, considering factors like deal closure.
Types of sales commissions
Let's now go through the types of sales commissions before we look at how we can account for them.
Straight commission
Under a straight commission plan, sales earnings are solely dependent on sales performance, without a fixed salary.
Salary plus commission
This common structure offers a base salary plus a commission, providing a stable income with performance-based rewards.
Tiered commission
A tiered commission rewards sales reps with higher rates as they reach specific sales targets or revenue levels.
Gross margin commission
Gross margin commission is based on the profit made from a sale, considering both revenue and costs, not just the sale price.
Special incentives and bonuses
These are additional financial rewards given for achieving certain milestones or completing special projects, and as a result—adding extra motivation beyond standard commissions.
How to calculate sales commissions?
Calculating sales commissions involves several key factors, including the structure of the commission, the volume of sales, the type of product sold, and the terms of the sale.
The different calculation methods depend on:
Commission structure: As seen earlier, there are different types of sales commission structures. Sales commissions are calculated based on the type of commission structure that your sales team employs.
Sales volume: The total sales generated by a salesperson directly impact their commission. Typically, as the sales volume increases, so do the commissions earned.
Product or service type: Commission rates may differ depending on the nature of the product or service sold. Some items may carry higher commission percentages due to their value or sales strategy.
Sales terms: The commission rate may also vary based on the terms associated with the sale. For instance, commissions may be calculated on a monthly, annual, or multi-year basis, affecting the overall sales compensation.
A few practical examples and formulas
Let’s say a salesperson sells $15,000 worth of product A at a 10% commission rate. Then the commission can be calculated as follows:
Commission = Sales Amount x Commission Rate
Commission = $15,000 x 0.10 = $1,500
In another example, a salesperson might earn a base salary of $2,000 plus a 5% commission on all sales. If they generate $50,000 in sales for the month, their total earnings would be:
Total Earnings = Base Salary + (Sales Amount x Commission Rate)
Total Earnings = $2,000 + ($50,000 x 0.05) = $2,000 + $2,500 = $4,500
Excel vs. automated tools: What’s the best option to calculate sales commission?
While many businesses use spreadsheets to manage commission tracking, dedicated sales commission software can offer a more streamlined and accurate approach. These specialized tools often include features such as automated calculations, customizable commission plans, and comprehensive reporting.
By reducing the risk of errors and saving time, sales commission software simplifies the management process for both supervisors and sales representatives. Investing in such solutions enhances transparency and oversight within your commission system and enables you to provide effective compensation for your sales reps. Furthermore, it also minimizes the complexities associated with managing sales commission accounting.
Regulatory framework: ASC 606
ASC 606, established by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB), significantly changed how companies account for sales commissions.
This framework affects sales commission accounting by requiring that commissions be recognized only when related revenue is booked. In this case, businesses must carefully track commissions to ensure they align with revenue recognition.
Understanding ASC 606 is essential for accurate sales commission accounting and maintaining clear financial reporting. Having said that, many startups are still grappling with the implementation of ASC 606, especially when it comes to accounting for sales commissions.
Ryan Dillard, the Chief of Staff and Director at accounting firm CBIZ ARC Consulting, pointed out in a webcast hosted by Airbase that—
"The challenge stems from the need to capitalize, and then amortize over time, commissions that are considered incremental expenses because they’re tied to contracts with performance obligations that are met over more than one reporting period."
Impact of ASC 606 on sales commission accounting
ASC 606 emphasizes amortization, meaning companies must spread the cost of commissions over the life of the related contracts.
Instead of treating commissions as direct expenses, businesses now recognize them as intangible assets aligned with revenue generation. This requires companies to estimate expenses and adjust them based on actual sales performance and customer retention.
Changes in accounting practices
Under ASC 606, the process of accounting for commissions has become more complex. Previously, companies could expense commissions at the end of the reporting period. Now, they must forecast commission expenses and revise these estimates based on sales outcomes. Any failure to comply would lead to significant penalties from regulatory bodies like the Securities and Exchange Commission (SEC), which monitors financial practices closely.
Business models affected
ASC 606 greatly impacts subscription-based models, especially Software as a Service (SaaS). These companies must set amortization periods for sales commissions, commonly between three and six years. What we need to understand here is that—while shorter periods can provide a clearer picture of actual amortized assets, longer periods may help reduce accounting disruptions. Businesses need to carefully evaluate their models to determine the best approach for their specific circumstances.
In addition to SaaS, ASC 606 also affects other business models such as e-commerce, telecommunications, and any industry relying on subscription or recurring revenue streams, as they all require careful management of sales commission amortization and revenue recognition.
To ensure compliance with ASC 606, businesses should consider several key steps:
- Establish clear commission plans that define structures, rates, and criteria for earning commissions.
- Develop processes for accurately tracking and calculating commissions based on performance metrics.
- Adjust accounting practices to align with the requirements for amortizing sales commissions over the contract term.
- Train finance and sales teams on the implications of ASC 606 to ensure understanding across departments.
- Utilize automated tools to streamline commission calculations and maintain compliance, reducing the risk of human error.
How to record sales commissions?
The accounting treatment of sales commissions varies based on whether you follow the cash basis or the accrual basis.
Under ASC 606, each commission should correlate with a customer. Subtopic ASC 340-40 requires continuous documentation of costs related to customer contracts, including commissions, travel, and advertising expenses. These costs must be capitalized as an asset and amortized over time to match revenue recognition.
When recording sales commissions, consider the following:
- The amount earned by the sales representative
- The date the commissions were earned, reflecting the sale date
- The appropriate expense account, typically the sales expense account
- The liability account for accrued commissions is, in most cases, the accounts payable account
Methods of recording sales commissions
We’ll first delve into when sales commissions can be recorded as expenses and as incomes.
As expenses
Sales commissions are recognized as expenses when earned. They are classified as selling-related operating expenses, typically recorded under Selling, General, and Administrative (SG&A) expenses. Commissions should not be classified as product costs and must be correlated with customer contracts as required by ASC 606.
As incomes
When your company earns a sales commission, it is recorded as revenue or as income. If the commissions are part of core operations, they are considered operating revenue. If not, they fall under other incomes. Commissions earned are recorded immediately under the accrual basis of accounting, ensuring compliance with ASC 606.
A step-by-step guide to journal entries
We will now outline the accounting treatment for sales commissions under both the accrual and cash methods.
Accrual method
Under the accrual method, commission amounts are recorded as an expense when earned, creating a corresponding liability for the amount owed to the salesperson. This method is more reflective of the economic reality of the transaction, ensuring that financial statements accurately represent the company's obligations. As per this method—the appropriate journal entries are made to recognize the expense and the liability, regardless of when the payment is actually made.
Cash method
The cash method records commissions only when they are paid out to the salesperson. This is comparatively a much simpler approach and may not provide a complete view of pending financial obligations. Under this method, journal entries are made at the time of payment—which means that expenses may not align with the revenue generated from sales. This method is often used by smaller businesses but can complicate financial reporting and compliance with standards like ASC 606.
Examples of complex scenarios
In cases like advances on commissions and recoverable draws, unique accounting entries are essential for accurately documenting the specific financial agreements involved. We will take a look at these different scenarios with the help of examples.
Advances against commissions
Advances against commissions involve prepaying sales representatives before they earn their commissions.
Example: If you pay Lisa a $1,500 advance, this creates a liability on your balance sheet.
The initial accounting for an advance against commissions to Lisa will be done as seen below:
Accounting for earnings and settling advances against commissions will be as follows:
Recoverable draws
Recoverable draws are temporary payments to sales representatives that are deducted from future commissions.
Example: If you provide Dave with a $1,200 recoverable draw and he earns $2,000 in commissions, he is then liable to receive the remaining $800 as commissions considering that $1,200 was paid to him earlier.
The initial accounting for the recoverable draw is:
Accounting for Dave's earned commissions and settling the recoverable draw:
Tax implications of sales commissions
Sales commissions are subject to tax laws that affect both employers and employees.
We're breaking this down to help you understand the tax requirements better:
Tax treatment for employees
Sales commissions are classified as ordinary income and are subject to various taxes, including federal, state, and local taxes. Employees should maintain accurate records of their commissions to facilitate smooth tax filings at year-end.
Tax treatment for employers
Employers need to ensure that they withhold the appropriate taxes from commission payments. This includes employee contributions to Social Security and Medicare. It's essential to keep track of tax filing deadlines throughout the year to prevent any penalties.
Business deductions and reporting requirements
Sales commissions paid by employers can often be deducted as a business expense, which may help lower taxable income. Specific regulations dictate which deductions are permissible. As such, it is best to consult with a tax advisor. Businesses need to ensure proper record-keeping, as it is critical for accurately reporting commissions paid and taxes withheld during the tax filing process.
Best practices and tips for sales commission accounting
Maintaining accurate sales commission accounting is crucial for businesses. Following the best practices mentioned below can help you streamline the process and facilitate compliance.
Ensuring data accuracy
Effectively managing commission expense accounting requires separating them based on different revenue streams. This means distinguishing the commission amount for products with varying revenue recognition schedules. Using an integrated sales compensation management solution can help ensure reliable data across multiple platforms.
Periodic reconciliation and audit tips
Conduct regular reconciliations of commission data. This will help you spot any discrepancies. In addition to this, you need to establish a consistent audit routine to verify the accuracy of commission calculations. This practice enhances transparency and fosters confidence in the accounting system.
Leveraging automation tools for efficiency
Utilizing sales commission software like Everstage can significantly improve the efficiency of commission management processes. Everstage offers automated ASC 606 reporting that simplifies expense reporting. With features such as straightforward amortization, waterfall views, and cohesive audit trails for revenue matching—Everstage helps businesses enhance accuracy and streamline their sales commission accounting processes.
Legal and compliance considerations
Ensuring compliance with legal standards surrounding sales commissions is essential for any organization. For this, it’s important to know the relevant laws and implement robust policies that can protect businesses from potential liabilities and foster a more transparent workplace.
Overview of relevant legal considerations
Understanding the legal aspects of sales commission agreements includes being aware of state and federal laws that may impact commission structures and payments. Legal considerations also extend to the proper classification of employees versus independent contractors. This distinction can affect commission eligibility and tax responsibilities.
Ensuring compliance with changing laws and regulations
Regularly review your commission policies to ensure they comply with current laws and regulations. You also need to stay informed about legislative changes that can help mitigate risks and avoid penalties. Moreover, consider training your staff on compliance issues, as it is vital for aligning with accounting standards.
Simplify your sales commission accounting system today
The complexities of accounting for sales commissions, particularly under ASC 606, highlight the need for clear structures and diligent compliance with legal standards. By following the above-mentioned best practices, you can maintain accurate recording and calculations of sales commissions and ensure regulatory adherence for your organization.
Leveraging sales commission software like Everstage can help organizations simplify this process and focus on their core operations while maintaining transparency and accountability.
