Subscription Finance
Revenue Recognition: Guide for Subscription Businesses
Revenue recognition is one of the most important accounting metrics for any business. It’s also one of the easiest to overlook in subscription finance and accounting.
Let’s imagine you’ve just made a sale: adding a new account worth $1,200/month for a contract of three years. It’s an exciting milestone for your company, worthy of celebration because you just made $43,200 in revenue, right?
Well… not exactly.
Because, according to standardized accounting principles, revenue should be recognized after you’ve delivered the service to your customer. And, so far, you haven’t really delivered anything to your new customer, except maybe a contract.
And even if you got that client to send you all $43,200 tomorrow, it still wouldn’t count as revenue. Why? Because the revenue recognition principle also doesn’t consider cash in your company bank account to be revenue.
If any of that’s confusing, don’t worry. Everything will make sense by the time you finish reading this guide on revenue recognition for subscription businesses.
Here’s what we’ll cover:
- How the standardized revenue recognition principle benefits your business
- The 5 step framework all businesses should follow to accurately recognize revenue
- The 5 criteria for recognizing revenue to ensure consistent financial reporting
- An example of the revenue recognition process for a subscription-based business
Before we dive into that first topic, let’s make sure we have a clear understanding of what revenue recognition means.
What Is Revenue Recognition?
Revenue recognition is the generally accepted accounting principle (GAAP) referring to the way a company records revenue earned.
Why is this principle needed? Because think about it: the term “earned” is relative. You could consider revenue to be “earned” when you have made a sale or after the cash has reached your bank account. The revenue recognition principle standardizes the process of reporting earned revenue so that there’s no ambiguity or inconsistencies in your accounting books.
The principle states that you can only recognize revenue after you’ve met the contractual obligations promised to customers.
Here’s why this principle is important for subscription businesses.
Why Is Revenue Recognition Important for Subscription-Based Businesses?
Revenue recognition is important because it provides transparency and consistency in financial reporting, which can impact tax liability, share price, and more. It also helps businesses manage cash flow more by giving them a better understanding of when they’ll receive payments.
For subscription-based businesses, revenue recognition is critical. The reason is that with subscriptions, customers are typically billed in advance for the product or service they’ll receive. If revenue isn’t recognized until after the product has been delivered, there could be a delay between when the revenue is earned and when it’s reported.
Without a standard practice for recognizing revenue, this delay could create problems for financial planning and decision-making based on the company’s financial health. By following the Accounting Standards Codification (ASC) 606 framework for revenue recognition, you can avoid these problems.
ASC 606 Framework for Revenue Recognition
In 2014, the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) standardized the process of recognizing revenue from contracts with customers in the ASC 606. This standardized process applies to all businesses, regardless of industry.
By following the 5 step process outlined in the ASC 606, you can ensure that your subscription business has a consistent method of recording revenue from contracts with customers. This also ensures consistency across financial records.
The 5 Critical Steps for Revenue Recognition
-
Step 1 – Identify the contract or agreement between the buyer and seller
Before moving on to the next steps, you’ll need to refer to the sales contract or purchase order between the customer and the business. -
Step 2 – Identify performance obligations as written in the contract
For subscription-based businesses, this is important because it’s not always clear what the customer is paying for. Are they paying for access to content, the use of a platform, or a mix of both? This needs to be clear for revenue to be recognized correctly. -
Step 3 – Determine the transaction price
Determine the exact amount of money the customer has agreed to pay for the goods or services. For subscription-based businesses, there are often different pricing models with differing transaction prices depending on the subscription tier. It’s essential to determine the transaction price for a contract so that you can recognize revenue correctly. -
Step 4 – Allocate the transaction price to the performance obligations
Determine how much revenue should be recognized for each performance obligation. Let’s say a customer has agreed to pay $1,000 per month for access to a platform, and the business has determined that the platform consists of two performance obligations (access to content and use of the platform) of equal value. Then, the business would recognize $500 of revenue toward the access to content obligation and $500 for the use of the platform. -
Step 5 – Recognize revenue as contractual obligations are met
As each performance obligation is satisfied, meaning the customer gets what they paid for, revenue is recognized. You may choose to recognize revenue as the contractual obligations are met for each customer contract or wait to recognize revenue from multiple contracts at the end of the month.
The 5 Criteria for Revenue Recognition
According to the International Financial Reporting Standards (IFRS), the following criteria should also be met before your company recognizes revenue:
- Risks and rewards of ownership have been transferred from the seller to the buyer (i.e. the company must deliver the product to the customer)
- The seller loses control over the goods sold (i.e. the customer must have the ability to use or consume the product or service)
- The collection of payment from goods or services is reasonably assured (i.e. it’s probable that the company will receive payment for goods or services)
- The amount of revenue can be reasonably measured (i.e. the company can calculate the revenue from the sale of goods or services with a reasonable degree of accuracy)
- Costs of revenue can be reasonably measured (i.e. the company can accurately calculate the costs associated with providing the goods or services)
These criteria ensure revenue is only recognized when it is probable that the company will receive payment for goods or services delivered.
Applying these criteria to a subscription-based business, revenue should be recognized once a customer has paid for a subscription. If a customer pays for a year-long subscription on January 1, the company should recognize revenue for that customer in twelve installments, one for each month of the subscription.
These criteria also provide clarity about how to approach recording revenue during common promotions and offers. If you offer a limited-time trial of your service, and the customer can cancel at any time during the trial without paying anything.
The collection of revenue isn’t assured until the free trial period is up and the customer has decided to become a paying subscriber. You know you can’t recognize revenue during the free trial period even if you have the customer’s payment on file.
Revenue Recognition Example for a Subscription Service
The revenue recognition principle gives you a standard framework for reporting earned revenue from contracts with customers. But how does the practice of recognizing revenue look? Let’s go back to the example we discussed in the intro:
Your business has a subscription service and just acquired a new customer with a three-year contract for $1,200/month. Now, let’s also say that, as standard practice, you also charge a one-time onboarding fee of $200.
How do you begin to recognize this revenue? You can recognize $200 of revenue once the onboarding process is complete. That contractual obligation has been met.
But what about the revenue from that three-year contract? Can you recognize the total revenue you expect to earn from that contract ($43,200) all at once? Unfortunately not, you first need to deliver the service. And since it’s a monthly contract, you’ll recognize $1,200 of revenue one month at a time as your customer continues to receive access to your service.
If your customer decides to cancel their contract at any point, your financial statements will still be correct. You’ll have only recognized earned revenue for the months that the customer actually used your service.
Bundling and Discounting Complicate Revenue Recognition
Say your company prices software at $800 per year and training at $200 per year. If you decide to bundle those two services together and sell the software at a discount for $500 while throwing training in for free, does that mean the training has no value in terms of generating revenue?
The current revenue guidelines require companies to estimate the SSP of each individual offering and allocate the total transaction price of the contract across each offering based on the relative SSP.
Here’s how the above example would play out:
- The SSP for the software is $800 while the SSP for training is $200.
- When you bundle Software and Training together, 80% of the bundle is allocated for software while 20% is allocated for training.
- Because the customer paid a total of $500 for that contract, the total Transaction Price is $500.
- Since the Transaction Price of this particular deal was $500, 80% of it ($400) will be allocated to revenue for software while 20% ($100) will be allocated to revenue for training.
There’s plenty of guidance on how to calculate allocations for bundled deals. But can you imagine implementing such advice for thousands of contracts without an automated solution? This will not only drown your revenue team but also slow down the pace at which you can roll out any changes to pricing and bundling.
Thinking about implementing a new packaging or bundling strategy? Without revenue automation, your pricing and bundling decisions could create a revenue nightmare for your finance teams. So ask yourself:
- Do we have the ability to automate the process of systematically separating (or “exploding”) bundles into distinct elements?
- Do we have the ability to automate the process of determining and applying SSP to each element in a bundle?
- Do we have the ability to automate the process of allocating the transaction price of a deal across the different elements within a bundle?
What About Revenue Recognition Automation?
Ever heard the term “set it and forget it?” That’s revenue recognition automation in a nutshell. By automating processes, there’s a greater consistency in accounting and accurate analytics. Revenue automation empowers businesses by utilizing the power of technology which realigns finance talent, while restructuring service delivery.
By doing this, companies see fewer errors because employees aren’t spending time on monotonous tasks, which after a while can be a field of errors based on the constant back and forth of manual processes.
Revenue recognition should be a top to bottom process that’s consistent and accurate as volume and complexities only increase over time. The IRS wants to know how revenue is tracked and valued, and having clean books is critical should you get audited. A company should not rely on its books being kept through a spreadsheet. By establishing these kinds of best practices that take away the threat of human error, there is a consistency within the accounting practices, which many companies see further economic gains, but also a real throughline that offers a clear look into their numbers across the board.
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Watch the 2022 State of Revenue Automation: How to Choose the Right Vendor to Automate ASC 606 & IFRS 15
Key Takeaways - Revenue Recognition FAQs
Revenue is the lifeblood of any business, so companies must follow a consistent and accurate method for recording it. The revenue recognition principle provides that guidance. Here are a few of the key takeaways that answer common FAQs about revenue recognition:
When should subscription revenue be recognized?
The revenue recognition states that revenue is recognized when you’ve received payment from your customers AND your company has met the performance obligations listed in the customer contract (i.e. you’ve provided the service).
When can you recognize subscription revenue from an annual contract?
If you provide a monthly service, you should NOT recognize revenue from an annual contract as soon as the customer pays you. Instead, you need to recognize the revenue one month at a time as the customer receives access to each monthly installment of the service.
What are the 5 steps for recognizing revenue according to the ASC 606?
The ASC 606 outlines five specific steps that must be followed to properly recognize revenue:
- Step 1 – Identify the contract or agreement between the buyer and seller
- Step 2 – Identify performance obligations as written in the contract
- Step 3 – Determine the transaction price
- Step 4 – Allocate the transaction price to the performance obligations
- Step 5 – Recognize revenue as contractual obligations are met
Why is it essential to follow the step-by-step revenue recognition framework?
By adhering to the five-step revenue recognition framework laid out in the ASC 606, businesses can be sure they are recognizing revenue in a way that is consistent and compliant with generally accepted accounting principles (GAAP).
How does the revenue recognition principle help subscription businesses?
The revenue recognition principle is especially important for subscription businesses, as they often have annual and monthly recurring revenue streams. The revenue recognition principle provides a framework for a consistent method for subscription businesses to follow when recording revenue. It also ensures that subscription businesses don’t over- or under-state their sales.
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