Managing and tracking revenue has always been an integral part of subscription-based service. Consider the most traditional example of a subscription business: The magazine company. The customer pays their annual subscription fee upfront to receive a monthly magazine. 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 its 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 it intends to deliver in the future, certain subscription revenue accounting rules must be followed to ensure the money is properly accounted. There’s a revenue recognition principle that must be obeyed. 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 subscription business called MovieWatch that offers a video streaming service.
- MovieWatch Inc is a software as a service (SaaS) 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 fee as part of the sign-up process.
- At the start of each 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 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.
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 first month has passed and the service has been delivered, MovieWatch can finally say it has delivered the service, which means it can recognize the full amount of that month’s sale as revenue. The ledger entries would look something like this:
Please note, 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 subscription business should be able at any given time to see:
- 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 subscription 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 only internal parties will ever need to see their financial statements. This overlooks the external parties that might need access to the businesses’ financial statements, including:
• a bank
• an investor
• a board of directors, or
• a minority shareholder.
- Business intelligence: Deferred revenue is a liability, not an asset. This is because it’s dependent on a commitment to deliver the subscription 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 businesses have long-term strategies that include going public. In preparation for going public, a business 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 subscription 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 business’s corporate revenues can be dramatically impacted by the amount of deferred revenue it carries forward into future periods.
- ASC 606: Revenue recognition is the key focus of the ASC 606 revenue standard, which determines the specific conditions under which income becomes realized as revenue. This revenue recognition standard took 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 a recommended approach.
- Spreadsheets: Many subscription businesses use a combination of Excel spreadsheets and sticky notes to track their deferred and recognized revenue. In general, spreadsheets have several issues, including:
• no audit trail
• reliance on formulas
• fewer reporting/forecasting capabilities, and
• a “flat” structure rather than data stored in a relational database.
- Stand-alone revenue recognition 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 business’s financial statements. In addition, these options often have many high internal costs in terms of initial development and ongoing maintenance.
- Integrated revenue recognition 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’s the solution? Digitally transforming your financial operations with a recurring billing platform that automates your revenue recognition. These adaptive platforms will help you manage and keep your recurring revenue business on track.
Customized subscription management platforms like Stax Bill 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 leveraging the recurring revenue model can provide the best balance between cost and benefit when meeting this important business need.
Check out this article to see if your subscription business is showing signs it’s outgrown its current billing process.
FAQs about Revenue Recognition
Q: What is revenue recognition in a subscription business?
Revenue recognition in a subscription business involves acknowledging the income earned from delivering services or products over the subscription period. This principle indicates that revenue is only recognized when a company delivers its service or product to the customer.
Q: What is the “rev rec” principle in a subscription business model?
The “rev rec” or revenue recognition principle is a standard in subscription revenue accounting where businesses charge a fee in advance. It states that revenue cannot be fully recognized until the service has been delivered over a designated period of time. This is also known as deferred revenue.
Q: What accounting entries are required for recognizing subscription revenue?
At the start, the total amount paid by the customer is tallied in ‘Accounts Receivable.’ The setup fee is recognized as ‘Earned Revenue,’ while the monthly fee is placed as ‘Deferred Revenue.’ As each month passes and the service is delivered, a part of the ‘Deferred Revenue’ is moved to ‘Earned Revenue.’
Q: How is revenue recognized in a fully prepaid annual front-end subscription?
Generally, the total amount is considered deferred revenue if a customer pays for the annual subscription upfront. Each month, a proportionate part of the total amount is moved to ‘Earned Revenue.’ This process continues until the end of the 12 months, when all the initially deferred revenue would have been realized as earned revenue.
Q: How do I manage my subscription business’s revenue recognition effectively?
For effective revenue recognition management, businesses use either spreadsheets, standalone software, or integrated software modules. The most cost-effective and accurate solution is to use a recurring billing platform that automates your revenue recognition.
Q: What is the importance of tracking revenues according to Generally Accepted Accounting Principles (GAAP)?
Tracking revenues according to GAAP provides visibility to both internal and external parties of the business’s financial standing. It aids in getting an accurate picture of cash flows, planning for public listing, correcting corporate tax calculations, and dealing efficiently with customer cancellations.
Q: What is ASC 606 in terms of subscription-based businesses?
ASC 606 is a revenue recognition standard that sets the specific conditions under which income becomes realized as revenue. It took effect in 2018 for public companies and in 2019 for private companies, focusing on how revenue from contracts should be recognized in a fair and consistent manner across industries.
Q: How does tracking deferred revenue benefit the business?
Tracking deferred revenue offers businesses an accurate calculation of both collected and recognized revenue. It allows for clear identification of refunds for cancellations and enables correct corporate tax calculations. It’s a crucial aspect for companies considering going public and for general business intelligence.
Q: Which industry-specific solutions exist for revenue recognition in subscription businesses?
Subscription management platforms like Stax Bill offer tailored solutions for revenue recognition. These platforms automate revenue recognition processes, allowing businesses to manage and track all aspects of subscription billing efficiently and effectively.
Q: What measures can a business take if it has different revenue recognition rules?
Different companies may require different revenue recognition rules and may decide to accrue revenue on a daily or monthly basis, depending on the level of accuracy required. Thus, it’s advised to use a platform or system that can be customized according to specific business needs.