ASC 606 & IFRS 15: How the new Revenue Standards will impact Subscription Companies

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The upcoming changes to revenue recognition standards are more than just a headache for your finance department. They can potentially impact the growth engines at the heart of any business—and subscription-based companies are particularly vulnerable to these consequences.

The impact on subscription companies is unique and different. How you prepare for it comes down to how you structure your subscription offerings, the type of contracts you plan to sell, and how you want to recognize revenue.

What’s changing and why?

In 2014, the Federal Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) issued new standards for recognizing revenue from contracts with customers. The result of a years-long effort, these guidelines will be instituted in 2018 for public companies and 2019 for private firms.

The goal was to simplify and harmonize revenue recognition practices. Currently, requirements for reporting revenue—a critical metric for evaluating a company’s financial performance—vary across different industries, jurisdictions and markets. These discrepancies create incongruent accounting results for economically similar transactions, rendering macro-level comparisons nearly impossible.

The new standards are based on one overarching principle: Companies must recognize revenue when goods and services are transferred to the customer, in an amount that is proportionate to what has been delivered at that point.

The five-step model

A five-step model summarizes the process for recognizing revenue from contracts with customers:

1. Identify the contract with the customer

2. Identify the separate performance obligations

3. Determine transaction price

4. Allocate transaction price

5. Recognize revenue when (or as) a performance obligation is satisfied

How will it impact subscription-based companies?

Compliance with the new standards presents a particularly difficult challenge for subscription-based companies, who can be tripped up at each step of the model.

Here’s where the trouble arises:

  • Subscriptions change frequently. Whether a customer upgrades, downgrades or adds a few seats, contract changes are the norm. In our experience, every subscription contract undergoes an average of four mid-term changes. These changes can make compliance with step 1 (identify the contract) difficult. In some circumstances, contract changes are handled as a modification to the existing contract, while in other situations, a separate contract is created. Revenue recognition is impacted accordingly.
  • Subscriptions are complex and rolled out over time, creating uncertainty for steps 2 through 5. The handling of common subscription characteristics—e.g. evergreen subscriptions, nonrefundable upfront fees—becomes problematic as companies must decide whether to recognize revenue right away or defer it. Similarly, usage-based pricing can make determination of the transaction price (step 3) more complicated than before. This all adds to the difficulty of accurately tracking contracted, recognized, and unbilled deferred revenue.

What are the effects on growth?

For subscription-based companies, the new standards could impact growth by hindering sales and marketing efforts. In order to achieve compliance, businesses may feel forced to adjust their contract designs, pricing models, and practices for modifying and managing contracts. Companies might also feel obligated to change the way they forecast sales and manage their sales teams.

Take volume discounts as an example. Your hard-working sales team proposes a form of tiered pricing. The team strongly believes the initiative will bolster growth—a top objective for every business. When a customer subscribes for a certain number of seats, the price per seat is reduced, either for future additional seats, or retrospectively for the already-purchased seats.

But your finance department is nervous. Contracts would be modified on the fly—both prospectively and retrospectively—and prices would be continually changing, roiling all 5 steps of the revenue recognition model. Their manual process can’t scale up and be compliant at the same time. You’re forced to choose compliance over growth, vetoing the tiered pricing proposal.

Compliance doesn't have to be at the cost of growth

Subscription-based companies may instinctually resolve that growth-promoting marketing and sales initiatives must bend to compliance. But it doesn’t need to be this way. With the right technology, the decision isn’t binary.

The design principle we followed when building Zuora Revenue Management is “touchless revenue recognition.” How can we make sure that you, the user, has to worry about revenue recognition as little as possible – let us handle the complexity for you. Revenue management in Zuora is automated and aligned with your other finance appliations. That’s right, no more spreadsheets. It takes 3 simple steps:

  • Design a set of rules for how you want to recognize revenue (including revenue distribution rules, performance obligation grouping rules, and more)
  • Assign these rules to each of your offerings.
  • Let Zuora do the work for you and watch revenue contracts, performance obligations, allocations, and revenue distribution happen automatically.

Don’t let your systems hold back your growth strategies. Watch a demo of Zuora RevPro and see how it automates even the most complex revenue recognition processes.

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