At first blush, the concept of annual recurring revenue (ARR) may seem simplistic. For the most part it is fairly simple, but it’s built to accommodate the sliding levels of complexity that often come hand-in-hand with a subscription-based business.
ARR is the value of recurring revenue of a business’s term subscriptions normalized to a single calendar year. What does that look like on paper? Let’s say Jack purchases a four-year business service subscription from Jill for $20,000. If we normalize the full-term revenue to a single year, our ARR would be $5,000 because that is the yearly income on that subscription.
This sounds like a really fancy way of just dividing revenue into yearly units, right? However, if this accounting principle is to be used correctly, there are some essentials to keep in mind.
To avoid any sort of confusion, single charges — or variable revenue — is to be accounted for separately. ARR only includes fixed contract fees. If any extra, non-subscription charges are lumped into ARR, it loses accuracy in tracking those funds. For instance, if Jack pays Jill for some additional consulting that is outside the parameters of his four-year subscription, that revenue has to be recorded separately from ARR, which remains at $5,000.
Contracts or subscriptions that have terms less than one year, such as month-to-month agreements, should not be recorded in ARR. The main reason for this is that shorter-term contracts often allow a subscriber to cancel the agreement within 30 days. This would complicate reporting if that agreement was calculated as ARR. Monthly recurring revenue (MRR) is a metric that’s more suited to that purpose.
ARR, as long as the term of the subscription is a year or more, is recorded the same no matter how the payments are structured. If Jack pays Jill the entire four-year amount of $20,000 upfront, the ARR stays the same at $5,000. On the flip side, if Jack pays monthly or quarterly, that also has no effect on how ARR should be recorded. This is essential for separating the funds on hand from simply the obligations made.
When normalizing revenue for a year, ARR can be calculated to the day, but only if the term is still a year or longer.
For instance, if Jack subscribes to Jill’s business services for an odd amount of days—say from August 12, 2015, to November 30, 2017—and Jill gives him a price of $13,000, this can be calculated as ARR. It’s just a bit more tricky:
Some accounting programs can handle the arithmetic automatically for you.
One ARR is a fairly straight-forward number to arrive at. It’s when the sums of multiple subscriptions from new or renewing clients, increases in subscription costs, upgrades, and add-ons are all seen together in a company’s ARR that the totals become useful.
An ordinary accounting system can provide only a nebulous concept of a subscription-based businesses growth, whereas changes in ARR year-over-year give a business owner a clearer idea about growth trajectory.
ARR and SaaS
Like many financial and/or technical topics, the basics of ARR are clear and straight-forward. But business in the real world rarely lends itself to textbook-case accounting ledgers. Real life gets messy, which is when really understanding the details becomes crucial.