Two balance sheet accounts sit at the center of every subscription business audit. Deferred revenue is the liability for cash billed ahead of service. Deferred commissions are the asset for sales compensation paid to win the contract. They move in opposite directions on a growing client, and both depend on judgments management controls. This guide covers the tests for each, with the focus on the commission asset, where the estimates hide.
Deferred revenue: what the rollforward should prove
Deferred revenue consists of customer billings and payments in advance of revenue being recognized. In an annual-billing SaaS company, contracts are billed in advance and are non-cancelable, so the balance is nearly all current. One public SaaS filer reported deferred revenue of $570.5 million at its January 31, 2024 year end, of which $568.7 million was current, which shows how closely the liability tracks a 12-month service cycle.
Build the rollforward from opening balance, plus billings, less revenue recognized, plus or minus adjustments for refunds, credits and acquired balances. Then test each line independently:
- Billings tie to the invoicing system and to cash receipts.
- Revenue ties to the general ledger and to the contract-level schedule.
- The ending balance ties to the sum of contract-level unearned amounts by customer.
An unbilled contract is not deferred revenue. Contracted but uninvoiced amounts are not recorded in revenue or deferred revenue, and belong in backlog or remaining performance obligations disclosure. See deferred revenue schedule and revenue recognition audit procedures.
Capitalized commissions under ASC 340-40
ASC 340-40 requires an entity to recognize as an asset the incremental costs of obtaining a contract with a customer when it expects to recover them. A cost is incremental if it would not have been incurred without the contract. A commission payable only on a signed deal qualifies. Costs that would be incurred whether or not the contract is won do not. A practical expedient lets an entity expense the cost when the amortization period would be one year or less.
Commissions on annual contracts do not automatically fall under the expedient. If the asset amortizes over longer than a year because renewals or the customer relationship extend the benefit, the expedient does not apply. Scope is wider than the commission check itself: one public filer defers sales commissions, related payroll taxes and incremental fringe benefits, and amortizes them together.
The amortization period is the judgment
The asset is amortized on a systematic basis consistent with the transfer of the related goods or services. Goods and services under specifically anticipated contracts count. The period is a judgment about how long the benefit lasts, similar to estimating a useful life. The public filer discussed below determined its period from its customer contracts, expected customer life and the expected life of its technology. A commission paid two decades ago is unlikely to relate to today's service.
Renewals drive the answer:
- If no renewal is expected, amortize over the initial term.
- If renewals are expected, based on experience, the period extends into them.
- If the renewal commission is commensurate with the initial commission, the initial commission relates only to the initial term. A renewal commission far below the initial commission points the other way.
The question is the period over which the related goods and services transfer, not the effort needed to win each contract.
Estimate changes: a real example
Filings show how much the period matters. A public SaaS company stated that it amortizes commissions, related payroll taxes and fringe benefits straight-line over a period of benefit of four years. It increased the period from three to four years effective August 1, 2022, as a prospective change in accounting estimate. It said the change benefited fiscal 2024 sales and marketing expense and net loss by about 1 percent of revenue, and fiscal 2023 by about 2 percent. It tests the period and impairment quarterly. Deferred commissions were $148.9 million at January 31, 2024.
The lesson for an audit file: a period extension flows directly to income. Obtain the support, such as cohort retention, contract terms and technology life, and evaluate whether it is a change in estimate rather than principle. Disclose it when material.
Impairment
Capitalized commissions are tested for impairment, and the same public filer evaluates the period of benefit and tests for impairment quarterly and whenever events could affect recoverability. Test against customers who churned, were downgraded or entered disputes. Churn without write-off of the related commission asset is a miss to look for.
Worked example
This is an illustrative example. A SaaS client signs a three-year, $300,000 contract (billed annually in advance at $100,000) and pays a 10 percent commission of $30,000 plus $2,300 of payroll taxes. Renewals carry a 2 percent commission. The 2 percent renewal commission is far below the 10 percent initial commission, so management concludes the asset relates to the initial term plus expected renewals. Management supports a four-year period using retention data.
Capitalized asset: $32,300. Annual amortization: $8,075. After the first year, the asset is $24,225. Meanwhile the first invoice posts $100,000 to deferred revenue and releases $8,333 per month.
If the customer terminates the relationship in month 20 and no renewal is expected, the remaining asset after 20 months is $32,300 less $13,458 of amortization, or $18,842. Unless it relates to expected future contracts, it is written off.
Audit procedures
- Obtain the commission plan documents and confirm which payments are incremental and which are not.
- Reconcile commissions capitalized to the payroll or commission system and to signed contracts.
- Test a sample of capitalized items to the order form, the contract start date and the amount paid.
- Evaluate the amortization period with retention data and contract terms. Test the policy for consistent application across new, expansion and renewal commissions.
- Recompute amortization and the rollforward.
- Test impairment against the cancellation and downgrade list.
- Cut off commissions on deals signed near year end.
- Recompute the current versus noncurrent split.
Add the items below to the PBC list and review ASC 340 contract costs for the disclosure requirements.
PBC items
- Commission plan documents and approvals
- Commission register by deal with contract IDs
- Deferred commission rollforward and amortization schedule
- Retention and churn cohort analysis
- Cancellation, downgrade and credit memo listings
- Deferred revenue rollforward and contract-level detail
Red flags
- Period extended without new data
- Expensed commissions that follow the same plan as capitalized ones
- Sales bonuses or accelerators included in the asset
- Deferred commission balance growing faster than bookings
- Canceled customers with unamortized balances
- Deferred revenue declining while billings are flat
Sources
- FASB ASC 340-40, Other Assets and Deferred Costs, Contracts with Customers
- Smartsheet Inc., Form 10-K for the fiscal year ended January 31, 2024, deferred revenue and deferred commissions disclosures (sec.gov/Archives/edgar/data/1366561/000136656124000062/smar-20240131.htm)
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