Originally published in Subscribed Magazine Spring 2019 as What’s Revenue Recognition Got to Do With Subscription Growth? by Angela Ngo, Director, Business Development at Connor Group.
Everyone thinks all C-suiters have an in-depth knowledge of accounting and finance issues. But, spoiler alert: they don’t. These are highly complex disciplines and most people without a CPA just aren’t equipped to keep up when their company’s accountants are geeking out over amortization schedules and IS / BS (Income Statement & Balance Sheet) impacts in a meeting.
As a CPA and Big 4 alumna, I’ve been one of those geeky accountants. But I’m a firm believer that not every person in business should have to go get a CPA license to understand the essence of financial statements and accounting. Let me help bridge your understanding. Talking about the Subscription Economy and revenue recognition (my two favorite topics) can get a little granular but I promise: I’ll do as little CPA-speak as humanly possible.
Before we get to recurring revenue and its impact on revenue recognition, let’s level set on the main components of financial accounting and external reporting: financial statements.
These statements are standard and all public companies must follow GAAP or IFRS rules. This ensures everyone is speaking the same “language” so when you look at the health of Company A compared to Company B, you know it’s an apples-to-apples situation.
One of the most important financial statements is the income statement, and a company’s revenue is the big number sitting at the top. It’s arguably the most important metric there is; at the very least, it’s the number the financial world pays the most attention to when making judgments and decisions about what a company is worth and whether it merits investment, loans, and other business considerations.
So as you might expect, GAAP or IFRS have tons (and tons and tons) of rules to ensure the revenue figure on your income statement is accurately captured and stated in terms that are consistent with everyone else in the public arena.
The most fundamental of these rules is that for all business with more than $5M sales per year, revenue and expenses must be stated on an accrual basis, not a cash basis. Accrual accounting means transactions must be recorded when the intrinsic value has transpired; not necessarily cash. That means you can’t consider something “revenue” until you’ve earned it; just because you have the cash doesn’t mean you can plug it into “revenue” in your income statement.
Here’s a fairly simple example. When I was a teenager, I mowed the grass every Friday afternoon and my dad paid me $10 for it every Sunday. If I had been a company, I could recognize $10 in revenue after I put away the mower on Friday afternoon even though I didn’t actually get the cash until Sunday. Conversely, if my dad paid me $10 on Thursday before I mowed the lawn, I couldn’t recognize revenue until I finished mowing on Friday.
Let’s take a more sophisticated example. You go to the Apple store and buy an iPhone. $1000 cash out of your pocket and into Apple’s. Apple can’t immediately book that $1000 to revenue on its income statement yet. That’s because Apple’s accounting team knows that when you buy an iPhone, they can only recognize revenue for the intrinsic value they’ve given you that day—the phone itself—not the items they’ll deliver later, like the warranty, which they call deferred revenue and represents a liability to fulfill future services.
Seems logical, right? But this is also why the recurring revenue model that’s the engine of the Subscription Economy is making accounting teams absolutely crazy.
In the subscription business model, products and services are rendered over time, at various junctures, and the amount of revenue you get to recognize for each product or service you provide requires complex math and compliance with a very lengthy set of rules. (The most current and applicable rules are ASC 606 and IFRS 15, which have created their own set of issues for accounting teams but we’ll reserve that for another time.)
Let’s consider an example of how you’d recognize revenue over time for a software subscription for $1,300 a year. I charge customers $100 to sign up and a $1200 annual subscription fee. The total payment comes in at once, so the accounting team has to determine the right policy for recognizing the daily revenue over time.
Here’s what the math looks like on just ONE transaction for someone signing up on January 15.
I’m an accountant and even I have a bit of a headache looking at this chart. Imagine you have 100 subscriptions, 1,000 subscriptions, 10,000 subscriptions. And imagine your customers are signing up on different days of the year. The pro-rata calculation alone is complicated, let alone tracking the earned vs. deferred revenue balances over time. Your accounting team can’t spin up a spreadsheet for every new subscription. It’s the opposite of scalable.
So because revenue recognition is ultimately the main figure that drives the investment world, subscription companies—big and small—must find a way to systematically recognize revenue.
Traditional IT ecosystems and ERPs only understand point-in-time orders, not complex contracts and over-time recurring revenue models. Moreover, spreadsheets, ERPs, and traditional revenue recognition processes already tax the revenue and finance teams too heavily during period close and year-end audits. Add in ASC 606, and everyone wants to just get by with compliance, adopt the new standards manually, and keep chugging along. But it’s not business as usual anymore.
In today’s world where every company is switching to an “as-a-Service” model, businesses need to have a dynamic ongoing relationship with customers. And what does this mean for revenue recognition? Complexity.
Let’s take a look at contracts, for example. Today’s businesses need to:
While customers have come to expect these kinds of options, a lot of businesses struggle with offering them. Why? Because of the downstream implications on revenue recognition. A single “contract modification” can potentially trigger hours of manual work.
So given that these new ways of selling are incredibly complex and could potentially break their back office, it’s no surprise that many CFOs and controllers choose to avoid these new models like the plague. But of course, we all see the problem here: Failure to adopt new business models means you’re inhibiting your business’s growth.
Finance teams THAT stand in the way of business growth and recognition complexity ARE really an unacceptable excuse for denying your customers flexibility and delight. There has to be a better way. Enter revenue recognition automation.
Revenue automation can help your business embrace X-as-a-Service revenue contracts with ongoing contract modifications, usage-based pricing models, and more. When your downstream systems are automated, your accounting team doesn’t have to spin up another spreadsheet, labor over another process, and create yet another workflow of controls and reviews. Similarly, when you want to sell in a usage-based capacity, your automated revenue recognition solution can automatically estimate, accrue, and true-up your revenue using the known variables.
Automating also means you significantly alleviate the compliance burden and risk of reporting inaccuracies. Where you previously relied on people for complex calculations and complex if-then revenue scenarios, you’re now relying on technology. Instead of IT, Excel, pivot tables and vlookups, you have a system that guarantees complete data capture, consistent revenue treatment, and seamless reporting for disclosures, management, audits, and more.
As more and more businesses transition to the Subscription Economy, it’s absolutely crucial that finance teams learn to harness the power of technology to keep up. It’s not just about today’s compliance requirements; it’s about tomorrow’s growth opportunities. And automation is the golden ticket.
Now that you understand what the hullabaloo over revenue recognition is, I hope you appreciate the importance and complex nature of work your accounting teams are grappling with each and every day.