Why Accounting for Commissions Matters

Sanj Sanampudi

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August 28, 2020

You are here because like Gwyneth Paltrow, you have finally decided that it’s time to learn more about accounting for commissions.  It doesn’t make you a nerd.  I mean, I like accounting, GP likes accounting.  You’re in great company. 

I won’t sugar coat it though. Accounting for commissions is so, so dry.  

But, it is actually quite important.  Commission accounting significantly impacts how investors, auditors, and tax authorities view your company.  There are 3 main areas where accounting for commissions matter:

  1. Performance benchmarks
  2. Audit and internal controls
  3. Statutory compliance  

Benchmarking and Accounting for Commissions

One of your go-to metrics is probably CAC, or Customer Acquisition Cost.  This metric measures all of the sales and marketing expenses (including commissions) incurred in a period divided by the number of customers gained in the period.  This number (coupled with the expected value of a customer), indicates how efficient your sales processes are, and how scalable and profitable your business can become.   

Internal CAC calculations tend to be very nuanced and make comparing companies rather difficult.  As a result, third parties (like investors) will typically use information directly from your financial statements because those numbers tend to be more standardized across businesses.  (Well, at least they used to be.)  Third parties will typically go to your Income Statement (also known as a P&L) to do this analysis.  The Income Statement allows them to compare your sales and marketing expenses, including commissions, to revenues as a proxy for CAC and other efficiency metrics.      

It’s far from perfect, and a little blunt, but this method is the only way to get an “objective” quantitative comparison from company to company.  

The Curse of Commission Expense Accounting

The problem with this method is that accounting for commission expenses has become quite complex under a new rule called ASC 606 (or IFRS 15 outside the US.)   This rule came into effect in 2018 and 2019, and fundamentally changed the way that we expense commissions. 

Essentially, this rule has forced accountants to view sales activities as part of a lifetime customer relationship.  Some sales activities establish a new long term relationship (like the commissions a typical AE gets!)  You must now expense those activities over the estimated customer lifetime.  Other activities further existing customer relationships and should be recognized over the contracted service period.  And, some sales activities may or may not even result in revenue.  Those activities should be expensed as incurred. (Don’t worry.  We have a decision tree to help you summarize this!)

You can see how complicated this gets, and the reality is that how you decide to account for commissions is somewhat subjective.  The TLDR: the accounting choices you make will have a significant impact on your benchmarks and how you are viewed against other comparables.    

The Importance of The Audit

An audit serves two high-level purposes:

a)ensuring there is no fraud

b)verifies the reporting is a faithful representation of what is really going on in your business

The audit process is fairly standard, with the most time usually spent in fieldwork.  During their fieldwork, auditors will verify that each type of transaction in your company was put on your financial statements in a complete, accurate, and timely manner.

If errors are found in the course of the fieldwork, it may require additional testing and another round of fieldwork.  If more errors are uncovered you will have a “note” on your audited financial statements.  Notes are bad.  Really bad.  Best case, it seems like you are sloppy and do not have a good handle on your data.    Worst case, you appear incompetent and fraudulent.

Fieldwork for Your Commissions Audit

Commission audits have two portions.  First, the auditor reviews that you correctly calculated payouts.  Then, the auditor verifies that you are correctly expensing those payouts.

Commission Payouts:  On the surface, this seems like the easiest part of your audit.  You have your commission workbook, you know how the math shook out.  Not so fast.

  1. Do you have signed comp plan agreements for the people you paid?
  2. Are the right people given the right formulas?
  3. Did you accidentally drag the formulas down incorrectly in the workbook?
  4. Were there any manual adjustments to the data?
  5. Have there been any manual adjustments to the payout?
  6. Have you documented and approved all manual adjustments?
  7. Did they actually get to payroll?

Commissions Expenses: Your auditors will also test that your expenses are recorded in compliance with ASC 606/IFRS 15.  This will boil down to two main questions:

  1. Are you recording this commission expense over the correct period?
  2. Are the customers still active?

Accounting for Commissions for International Offices

If you operate in (or plan to operate in) multiple countries and/or through multiple legal entities, you must file taxes separately for each entity.   The problem is that many services companies contract on behalf of a parent entity, so the revenue (and customer payments!) all go to the parent company.  The local company is paying all of the expenses related to those employees, including the commissions.

So, the local company is at a loss, and that country would never collect any tax revenue from you.  Do you think that’s going to fly? 

Enter the concept of “Transfer Pricing”.  The fundamental idea of transfer pricing is to try to record the accounting of these transactions as if an independent third party were performing and billing for these services.  In accounting parlance, this is an “arm’s length transaction”.   You typically need an independent analysis to justify the method of pricing,  for determining that pricing, but they generally all come around giving the local entity a set profit margin. 

Without this, you may run into compliance issues, which will impact your ability to operate in that country.

Intercompany and Transfer Pricing for Commissions, An Example

You work for a company headquartered in the US, and you open an office in the UK to sell to and service your UK customers.  Your UK team closed $100K in revenue, with $10K of commissions expense.  

The US Company would get $100K in Revenue and $0 in Expense, a profit of $100K 

The UK Company would get $0 in Revenue and $10K in Expense, a loss of $10K.  

If you’re the UK tax officer, you’re pretty salty.  You can’t tax a loss, and you know that this team actually generated substantial income that you can’t tax.  

So back to our example, suppose we have a 20% margin requirement in our US-UK transactions.

The US Company would get $100K in Revenue and $12K in Expense (10K commission + 2K margin), a profit of $88K 

The UK Company would get $12K in Revenue (what the US is billed for commissions) and $10K in Expense (what you really paid the rep), a profit of $2K.  

In this case, the UK gets some tax revenue.

Now, this is just a stylized example.  The reality is much, much more complex than that.

Parting thoughts

Congratulations, you made it through a blog post on accounting!  You are just like Gwyneth Paltrow!

Hopefully, you now understand how accounting for commissions impacts:

  1. Performance benchmarks
  2. Audit and internal controls
  3. Statutory compliance  

And even though accounting for commissions is very technical, it doesn’t have to be hard.

Check out how Concert makes your commission accounting completely turnkey.   Book a demo here.

  

 

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