Managing and tracking revenue has always been an integral part of subscription based service. Take, for example, the most traditional example of a subscription business: The magazine company. The customer pays their annual subscription fee upfront to receive a monthly magazine and in exchange, the magazine company promises to deliver a new issue every month for 12 months.
The subscription business model fundamentally changes the nature of the interaction between the business and the customer. The fundamental distinction is that a business charges customers a fee in advance for services the business will deliver over a period of time. The transaction moves from a one-time exchange of goods for cash to an ongoing cash flow interaction.
When a business charges money for a service they intend to deliver in the future, certain accounting rules must be followed to ensure the money is properly accounted. There are revenue recognition rules that must be followed. This is often abbreviated as "rev rec" and sometimes called deferred revenue.
How does revenue recognition work?
Let’s take a look at an imaginary company called MovieWatch that offers a video streaming service.
- MovieWatch Inc is a SaaS (Software as a Service) business that makes movie streaming software. A customer can use MovieWatch to watch movies and television shows.
- MovieWatch charges a monthly subscription fee of $19.99 as well as an additional $100 setup as a part of the sign up process.
- At the start of each new month, MovieWatch charges the customer another $19.99. As long as the customer continues to pay, MovieWach will continue to provide access to the service.
On day one, MovieWatch has collected $119.99. The money is in their bank account. But not all of this money can be recognized as revenue because MovieWatch has not yet delivered the services to that customer. If MovieWatch decides tomorrow to stop providing the service, the customer will have paid $119.99 for 30 days of access, and only received one day. For such an instance, Financial Accounting Standards Board (FASB) accounting rules require MovieWatch to defer the revenue.
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When the customer pays their first month of service along with their setup fee, MovieWatch needs to account for the service portion of that money by placing the balance in a deferred revenue account. The accounting ledger entries would look this:
When the month has passed, and the service has been delivered, MovieWatch can finally say that they have delivered the service, which means they can recognize the full amount of that sale as revenue. The ledger entries would look something like this:
Please note, that different companies could require different revenue recognition rules and may decide to accrue revenue on a daily or monthly basis depending on the level of accuracy required. From a financial reporting perspective, a business should be able to see at any given time how much money it has collected from customers for subscription revenue, how much of that money is still in a deferred revenue account, and how much of that revenue has actually been recognized because the service has not been fully delivered.
Why is revenue recognition important?
There are a number of reasons businesses should track their revenues according to Generally Accepted Accounting Principles (GAAP).
- Visibility: Many small to mid-sized businesses do not account for deferred revenue because they think that only internal parties will ever need to see their financial statements. This overlooks the external parties that might need an access to the businesses financial statements: A bank, investor, board of directors, or a minority shareholder.
- Business intelligence: Deferred revenue is a liability, not an asset because it is dependent on a commitment to deliver the business services. Getting an accurate picture of cash flows and the business’s revenue requires deferred revenue to be properly tracked.
- Businesses looking to go public: Some companies have long-term strategies that include going public. In preparation for going public, a company with subscription services and revenue recognition implications must show financial statements that track deferred and recognized revenue properly.
- Clear identification of refunds for canceling. Although most monthly services are generally non-reimbursed, the same cannot be said for annual subscriptions. By accurately tracking deferred revenue it becomes possible to handle customer cancellations quickly and efficiently.
- Corporate tax calculations. A company corporate revenues can be dramatically impacted by the amount of deferred revenue they carry forward into future periods.
- ASC 606: Revenue recognition is the key focus of the new ASC 606 standards, which determine the specific conditions under which income becomes realized as revenue. These new standards will be taking effect in 2018 for public companies and in 2019 for private companies.
How do businesses implement deferred revenue and revenue recognition?
The approach to managing deferred revenue and revenue recognition depends on the scale of the business and the complexity of the scenarios. In general, businesses tend to take one of four approaches to rev rec management:
- Do nothing: For all the reasons discussed above, this isn't the recommended approach.
- Spreadsheets: Many businesses will use a combination of Excel spreadsheets and sticky notes to track their deferred and recognized revenue. In general, spreadsheets have several issues: No audit trail, reliance on formulas, fewer reporting/forecasting capabilities, and a "flat" structure rather than data stored in a relational database.
- Stand-alone rev rec software: The output is generally the journal entries to be entered into the accounting/ERP software, either manually or via an import. These tools are generally better than excel spreadsheets, but only partially bridge the gap to the company's financial statements. In addition, these options often have many high internal costs in terms of initial development and ongoing maintenance.
- Integrated rev rec software: Some accounting packages (Intacct, Oracle, SAP, etc) have built-in revenue recognition modules available. These are tightly integrated to the ERP/Accounting system, which provides better overall visibility into transaction history and reporting. However, these systems tend to be on the upper end for cost and are frequently out of reach for medium sized businesses looking to introduce more mature accounting practices.
What is the solution? Acquiring a billing platform that automates your revenue recognition will help you manage and keep your recurring revenue business on track.
Customized Subscription Management platforms like Fusebill are specifically designed to help manage and track all aspects of subscription billing, including Revenue Recognition for Subscription Models. Platforms specifically designed to meet the needs of modern online businesses adopting the recurring revenue model can provide the best balance between cost and benefit when meeting this important business need.