When the ASC 606 revenue recognition standard went into effect, Steve Judge had a monumental task on his hands. As vice president and assistant controller of CDK Global, he had $2 billion in revenue from business operations in over 100 countries to account for.
At the time, CDK Global provided IT and digital marketing solutions to approximately 30,000 automotive retail locations and manufacturers. Despite this, it managed to achieve compliance in time.
Today, Judge is the business’s vice president of finance transformation, and he believes ASC 606 is an opportunity, not a burden.
ASC 606 revenue recognition: A refresher on deferred vs earned revenue
Before we get into how Judge and others like him achieved compliance, let’s review ASC 606. The standard—which went into effect for public companies in January 2018 and for private companies a year later—attempts to level revenue recognition across businesses and industries.
By identifying revenue as recognized or deferred, subscription-business financial statements can be more accurately compared to those of other business models.
Recognized revenue: earned revenue from products and/or services which have been both paid for by and provided to customers
Deferred revenue: revenue from products and/or services which have been paid for by customers, but not yet provided to them (deferred revenue is considered a liability)
ASC 606 revenue recognition helps businesses—and outsiders—see what revenue has and hasn’t been earned at any point in time, which makes for better analysis and forecasting. This change has been challenging a number of accounting teams, but it doesn’t have to.
Subscription businesses benefit from revenue recognition—here’s how
It’s tempting to think of revenue recognition as a burden, even a risk. Consider asset optimization software business Aspen Technology, which recently announced it’s unable to file its annual report for the fiscal year ending June 30, 2019. The problem? Difficulty while transitioning to meet ASC 606 standards.
Subscription management platform Zuora was also affected by the challenge to meet the ASC 606 deadline. While working to implement revenue recognition compliance measures for its new customers, the company experienced delays. These delays ate away at its resources for implementing these measures for its core business, and the company failed to report the adverse affects. As a result, Zuora had to reduce its projected revenue for 2020, and now faces a shareholder class action lawsuit as the company’s share price fell nearly 30% as a result of the incident.
However, for those able to tackle revenue recognition more seamlessly, the advantages are clear. Aetna anticipated correctly that the new revenue recognition standard would increase its revenue in 2018. Universal Technical Institute also credited early adoption of the new standard with a non-cash increase in equity.
In fact, the EY Revenue Recognition Survey found that 94% of CFOs and CIOs agree implementing revenue recognition changes will deliver a value return that will exceed their investment over the long term. And that’s not all. Other reported benefits from implementing ASC 606 include:
- improved data quality and data-driven performance insights (42%)
- enhanced risk control and compliance (39%)
- transformed systems and greater process automation (38%), and
- identification of strategic cost reduction opportunities (38%).
How do successful subscription businesses ensure accurate revenue recognition?
Let’s explore some scenarios and the proper practices that should be followed for each.
1. Typical subscription contracts
Customers pay a set price for most subscription business offerings, for example, $30 for a 30-day software subscription. On the first day, only 1/30th of that subscription is provided to the customer. As a result, the business can recognize just $1 as earned revenue, and still owes the customer $29 worth of usage. This means $29 remains deferred revenue on the first day.
Each day of the month after that, the business can recognize another $1 as earned revenue until the entire month of service has been delivered and the entire fee has been recognized.
2. Hybrid contracts
Hybrid pricing for subscription businesses often means bundling recurring and one-time charges, and possibly even usage-based charges. In this case, each type of charge is handled separately.
Standard subscription charges are handled with the typical method described above, while one-time and usage charges are recognized as earned revenue immediately once payment is made and the product/service is rendered.
3. Contract cancellations and refunds
Early contract cancellations affect revenue recognition for many subscription businesses. For example, if a customer cancels partway through a no-refund contract, all remaining deferred revenue on that account is immediately earned. The customer has given up access to products or services for the remainder of the contract, so the business is no longer liable.
For businesses that offer refunds for unused subscription time, deferred revenue gets cut by the amount of the refund, with any remainder recognized as earned revenue.
4. Compensations, promotions, and other credits
If your business runs a promotion that adds a free month to a customer’s annual subscription, this also changes revenue recognition. The free month cannot be worth $0 under ASC 606, because it is part of an existing subscription.
For example, let’s say a customer paid $600 for a year of service starting in January. With that subscription, they were offered an additional month of service free of charge. Rather than recognizing the $600 annual fee over the 12 months…
$600/12 months = $50 per month recurring revenue
…your business would instead recognize the annual fee over 13 months to account for the free month.
$600/13 months = $46.15 per month recurring revenue
Therefore, your business would recognize $46.15 as earned revenue each month over the 13-month duration of the subscription.
Automate revenue recognition for subscription business success
If revenue recognition sounds complex, that’s probably because it is. And, as subscription businesses scale, so do the demands on billing, invoicing, and accounting.
Ultimately, compliant revenue recognition cannot be performed manually. Steve Judge at CDK Global knew this from the start. He also discovered two keys to ASC 606 automation success along the way.
- Data integrity is critical for revenue accounting automation
- Successful implementation requires cross-functional collaboration
An intelligent subscription billing platform automates revenue recognition, reducing manual labor and the risk of errors. And it ensures compliance, no matter how complex a business model is, or how many changes customers make within a billing cycle.
Subscription billing software can also integrate with other business software to automate sign-ups, activations, billing, usage, provisioning, and notifications. Unified data provides a single source of truth for business leaders and their teams. This data integrity and cross-functional agility lays the foundation for more than just revenue recognition compliance; it provides a platform for subscription business scalability and success.
FAQs about ASC 606
Q: What is ASC 606?
The ASC 606 is a revenue recognition standard that attempts to level revenue recognition across businesses and industries. It recognizes revenue as either earned (revenue from products/services which have been both paid for by and provided to customers) or deferred (revenue from products/services which have been paid for by customers, but not yet provided to them).
Q: What is the impact of ASC 606 on subscription-based businesses?
Subscription-based businesses need to be especially mindful of ASC 606 as it outlines how and when the revenue should be recognized. The standard has helped businesses better understand their earned and deferred revenue, allowing for more accurate financial analysis and forecasting.
Q: How do businesses recognize revenue according to ASC 606?
For subscription businesses, revenue is generally recognized daily, with a fraction of the total subscription cost considered as earned revenue each day of service delivery. Deferred revenue makes up the remaining amount yet to be provided to customers. The recognition process changes slightly in case of hybrid pricing, promotions, or early cancellations.
Q: How does ASC 606 affect a business upon early contract cancellation?
In case a customer cancels a contract partway with no refund provision, under ASC 606, all remaining deferred revenue on that account is immediately recognized as earned. If a business offers refunds for unused subscription time, deferred revenue is reduced by the amount of the refund, with any remaining amount recognized as earned revenue.
Q: What are the benefits of implementing ASC 606?
The implementation of ASC 606 has been reported to improve data quality and insights, enhance risk control and compliance, aid in process automation, and identify strategic cost reduction opportunities. It has also been found that the value returns from implementing these changes can exceed the initial investment over the long term.
Q: Why is automation critical for compliant revenue recognition under ASC 606?
Revenue recognition, according to ASC 606, can prove to be complex, especially as subscription businesses scale. Manual revenue recognition can lead to errors and non-compliance. An intelligent subscription billing platform can automate the process, reducing the risk of errors and ensuring compliance, irrespective of business model complexity.
Q: What challenges might businesses face in transitioning to meet ASC 606 standards?
Transitioning to meet ASC 606 standards can be challenging. A business might face difficulties in implementing revenue recognition compliance measures, which can lead to delays and negatively affect the business. This could potentially result in a reduction of projected revenue and, consequently, a fall in the company’s share price.
