Software Sales Commissions and Earnings Quality
How accounting for contract costs is impacting the earnings of 70 big software names
We are continuing our review of the software industry with a look at accounting for costs to obtain contracts. Selling software is a very time-consuming and expensive process. Commissions paid to sales staff typically comprise the lion’s share of these costs, but they may also include legal fees, travel and dining, and setup/customization costs.
While these all represent major upfront cash outflows, the contract they result in will benefit the firm over time. Therefore, a company is allowed to capitalize amounts that are deemed “incremental to the contract” meaning that they would not have been incurred if the contract had not been obtained. These amounts are then amortized over the period that the sales contract is expected to benefit the company. Consider the disclosure on deferred commissions from Samsara’s (IOT) 2022 10-K:
“Deferred Commissions—The Company capitalizes commissions paid to sales employees and the related payroll taxes, as well as commissions paid to referral partners, when customer contracts are signed. These costs are recorded as deferred commissions on the consolidated balance sheets. The Company determines whether costs should be deferred based on its sales compensation plans and if the commissions are incremental and would not have been incurred absent the execution of the customer contract. The Company amortizes sales commissions paid on the initial contract over an expected period of benefit, which the Company has determined to be five years. The Company has determined the period of benefit by taking into consideration its customer contracts and the duration of its relationships with its customers and the life of its technology. Commissions paid upon the renewal of a contract are amortized as expense ratably over the renewal term. Amortization of these costs is included in sales and marketing expense on the consolidated statements of operations and comprehensive loss.”
We do not have a problem with the practice of capitalizing contract costs in the spirit of matching the timing of expenses and the recognition of revenue. However, whenever a company deviates from cash accounting, it introduces the potential for earnings quality distortions. Under cash accounting, commissions would be expensed immediately. By delaying the recognition of the expense, EPS is boosted. We have yet to see a software company adding the amortization of sales commissions back to non-GAAP earnings (yet), so in virtually all cases, these amounts impact non-GAAP earnings as well.
When the company matures and growth normalizes, the amortization of old commissions will approximate the payment of new commissions. However, when growth is high, commissions paid will far exceed the amortization of older commissions which will inflate earnings. As we will see, this effect is more than capable of generating the bulk of EPS for a software company growing rapidly, especially when it utilizes a longer amortization period. It also can play a role in beating earnings forecasts when the payment of commissions jumps unexpectedly.
Analysts should consider the following factors when assessing how accounting for contract costs is impacting their companies’ earnings:
1) A longer benefit period means less reliable and more volatile earnings
Benefit periods are based on estimates and assumptions and typically range between 3-5 years. It is very important to realize that, as explained in the IOT policy above, the benefit period is not simply how long the contract runs but rather is an estimate of how long the relationship that resulted from the sales effort will benefit the company. In most cases, the benefit period is significantly longer than the initial contract term as it includes an allowance for expected future renewals of the contract.
The intangible nature of these deferred costs becomes apparent when companies are forced to write down their carrying value because of cancellations or changing business conditions. This is a regular occurrence in the industry. Therefore, amortization of contract costs for companies with 4-5 year terms deserves closer scrutiny than those being amortized over 2-3 years.
As an example, Cloudflare (NET) and Freshworks (FRSH) utilize a more conservative 3-year benefit period with NET producing a steady 2-3 cents in EPS from this source while FRSH is producing virtually nothing. In contrast, Palo Alto Networks (PANW) and Elastic (ESTC) use 5-year benefit periods. PANW has seen this EPS source swing from -12 cents to 19 cents in recent quarters while ESTC has seen it swing between 3 and 17-cents.
2) Longer benefit periods are a double-edged sword
While longer benefit periods mean less expense is recognized, that expense will stick around longer. When the company is growing rapidly, it will be paying out more in cash commissions than it is recognizing in contract amortization expense. However, the amortization of commissions from earlier deals is a fixed cost that will linger into the future. If the pace of signing up new deals slows, cash commissions will fall while amortization will remain high for the rest of the benefit period. This may lead to an effective drag on earnings where the company is recognizing more expense than it is paying out in cash.
For example, Teradata (TDC) was regularly beating forecasts by a significant margin. However, in the last three quarters, the impact of deferring commissions turned into an EPS headwind of -4, -8, and -8 cents in the September, June, and March quarters, respectively. In that time, TDC reported earnings in line with estimates twice and only beat once by 3 cents. Similarly, Salesforce (CRM) routinely beats estimates by 20-30 cents. However, in the October quarter, the beat was only 5 cents when the commission accounting headwind was 19 cents and in the April quarter, the beat was only 8 cents when the headwind was 20 cents.
3) The benefit of delaying commission expenses can be material
When a software company is growing rapidly and the signing of new deals results in huge commission spending, the gap between cash spent and older commissions amortized can be huge relative to reported earnings. We also believe this can impact whether a company beats or misses earnings forecasts. For example, Samsara (IOT) routinely beats estimates by 3 cents, but the spread between cash commissions and amortization is routinely 2 cents. Likewise, WorkDay (WDAY) beat estimates by 12 cents last quarter but gained 10 cents from this source. Note that both utilize benefit periods of 5 years.
4) Commissions can also be an early indicator of accelerating or decelerating growth.
When the level of capitalized commissions jumps, it should indicate healthy business activity in the form of new deals and/or renewals.
5) Normally renewals are amortized more quickly – over 1-2 years vs. new customer contracts at 3-5 years.
Sometimes you can see what is happening by looking at the changes in amortization and the amount capitalized over time. New customer commissions and costs tend to be higher than any commissions paid on renewals. This would drive up both the amount capitalized and the total accrual. However, the longer amortization period would mute the impact on the expense.
To illustrate with some numbers, if a new contract has $50,000 in costs that are capitalized over five years, it has $2,500 per quarter in amortization, or 5% of the total accrual. However, a renewal may have an $8,000 commission but is amortized over the one-year life of that contract. That is $2,000 in amortization per quarter or 25% of the accrual. So having more new contracts makes the amortization as a percentage of the total accrual go down. Having more renewals makes the amortization percentage rise.
For this report, we examined 70 software companies with market capitalizations of more than $5 billion and highlighted four different groups:
Companies where the earnings benefit of deferring commissions represents a material amount of reported earnings
Ones that may be about to face earnings headwinds from a decline in benefit from deferring commissions
Ones that may be about to enjoy a positive inflection point where falling accruals are leading to lower amortization relative to the new commissions being deferred
Ones where amortization is falling relative to deferred commissions which may indicate that new contracts are rising in the mix of new business.
Let’s get Behind the Numbers…