Imagine the most traditional example of a subscription business: The magazine company. The customer pays their annual subscription fee up front to receive a monthly magazine, and in exchange the magazine company promises to deliver a new issue every month for 12 months. This model has been well adapted to a wide variety of online business services. A great example is online accounting software. A customer pays an annual fee to access the online accounting software, and in exchange the software company promises to provide the customer access to their tools for the duration of that year.
The subscription business model fundamentally changes the nature of the interaction between the business and the customer. The transaction moves from a one-time exchange of product for cash to an ongoing interaction where cash flows to the business periodically, and services are provided to the customer continuously. The fundamental distinction of the subscription business model is that the business will charge customers a fee in advance for services the business will deliver to the customer over some period of time.
But there's a catch: When a business charges their customers money for a service they intend to deliver in the future, certain accounting rules must be followed to ensure the money is accounted for properly. Specifically, there are revenue recognition rules that must be followed. This is often abbreviated as "rev rec" and sometimes called deferred revenue.
What is revenue recognition?
Just because a business has collected money from a customer, that cash is not necessarily "recognizable" as revenue to the business. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) both say that a business cannot say the money is "theirs" until they have actually delivered the goods or services to the customer. At the most basic level, this means a business has to track how much money they have collected from customers separately from how much of that money can actually be "recognized" as revenue because they have delivered the services for which that money was paid.
Confused? You're not alone. The Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) have been working for a half-dozen years to unify various standards and policies, and just this year released new comprehensive policies on the topic. We can break this down into a more basic example that will help explain the topic.
How does revenue recognition work?
For our purposes, let's distill the concept down to this example:
- Acme Corp is a software business that makes inventory tracking software. A customer can use Acme's software to track the different products they sell, including quantity available and the date they should place their next order to restock.
- Acme Corp's software is accessed online (Software as a Service, or "SaaS"). Their customers have to come to the website and login to gain access to the software and see the list of their inventory products' information.
- Acme Corp charges a monthly subscription fee of $79.99 for access to the service. The customer is charged the first month's $79.99 fee as a part of the signup process.
- Once the customer has paid the $79.99, they immediately have access to the software for the next month.
- At the start of each new month, Acme Corp charges the customer another $79.99. As long as the customer continues to pay the monthly fee, Acme Corp will continue to provide access to their software.
On day one of the customer's subscription, Acme Corp has collected $79.99. The money is in their bank account. But the money cannot be recognized as revenue because Acme Corp has not yet delivered the services to that customer. If Acme Corp decides tomorrow to stop providing their inventory tracking software, the customer will have paid $79.99 for 30 days of access to the software, and only received one day. To account for this discrepancy between money the customer has paid and services the company has provided, FASB accounting rules require Acme Corp to defer the revenue, and then recognize the revenue as the service is provided.
When the customer signs up and pays their first month of service, Acme Corp needs to account for that money by placing the balance in a deferred revenue account instead of directly into revenue. The accounting impact would look something like this:
Account Debit Credit
Accounts Receivable 79.99
Deferred Revenue 79.99
When the month has passed, and the service for that month has been completely delivered, Acme Corp can finally say that they have delivered the service to the customer, which means they can recognize the full amount of that sale as revenue. The accounting impact would look something like this:
Account Debit Credit
Deferred Revenue 79.99
From a financial reporting standpoint, a business should be able to see at any given time how much money they have 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 been fully delivered to the customer.
Why is revenue recognition important?
There are a number of reasons businesses should track their revenues according to GAAP, including adherence to Revenue Recognition rules.
- Visibility for external parties: Many small to mid-sized businesses do not account for deferred revenue properly — or at all. The rationale is generally that they are not, and have no intentions of becoming, a publicly traded company, so only internal parties will ever need to see their financial statements. However, this overlooks the various external parties that still might need access to the businesses financial statements: A bank or investor when the business looks to finance growth; a board of directors with oversight of the company; minority shareholders that want an accurate picture of the cash position of the business. Just because the business isn't public doesn't mean revenue needn't be accounted for properly.
- Business intelligence: Deferred revenue is a liability, not an asset, because it is dependent on the business following through with its commitment to deliver the services. Understanding an accurate picture of cash flows and the business's revenue requires deferred revenue to be properly tracked.
Building on the Acme Corp example above, imagine the subscription fee was yearly instead of monthly, at $899.99 per year. On the day of launch, Acme Corp has 1000 customers signup and pay, meaning they have collected $899,990. If Acme simply records this as revenue, business managers will see an overstated cash position. If they decide to use this cash to hire 10 new developers and build new product features, the company exposes itself to risk if anything negative happens to that existing subscriber base. (Example: Customers cancel early, a patent lawsuit forces them to stop providing the service, etc.) It is thus important to have the deferred revenue tracked separately from the recognized revenue so the business has an accurate picture of their actual revenue now, and expected revenue for each month over the year as those services are delivered, so they can make informed business decisions.
- Businesses looking to go public: While the business may not currently be publicly traded, some companies have long-term strategies that include going public as one of several possible cash out strategies. 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. This will be true not only of the current year, but of previous years as well, so that prospective investors can accurately compare year-over-year performance as apples to apples. If previous years did not follow revenue recognition practices, the financial picture between years that do not and years that do track according to these practices will look very different. Specifically, for a full subscription cycle it will generally appear that revenues take a large hit for companies that start managing revenue recognition late in the game.
In our Acme Corp example above with an annual subscription of $899.99, if Acme Corp does NOT adhere to revenue recognition practices, and adds 1000 customers per month for the first year, it would appear they earned $899,990 per month, or $10,799,880 for the year, with flat revenue growth.
If Acme Corp did adhere to revenue recognition practices, they would still collect the same amount of money over the year. However, they would only recognize 1/12 of the total subscriber base fees every month. So at the end of month one they would recognize 1/12 of that month's total subscriber base, or $74,999. At the end of month two, when they have a total of 2000 subscribers, they would recognize 1/12 of the 2000 subscription fees, or $149,998. This trend would continue through the end of the year, such that in the 12th month, Acme Corp would be recognizing $899,990 per month. Note that at this point they have gone through one full year of a subscription cycle, and have now "caught up" to the monthly amount they would be recognizing on a cash basis. But comparing the "month to date" performance of 2014 to the "month to date" of the 2015 year would be very different when compared to a cash basis method of accounting.
Take this exercise a step further, and imagine two or three year subscription terms, and how long it would take for the new financial statements to "catch up" to the old financial statements if revenue recognition practices aren't used from the start.
Advanced revenue recognition (VSOE, EITF-0801)
Businesses selling software or subscription services recognize that this can be cumbersome. Moreover, businesses like to have cash recognized as cash as soon as possible. Some clever businesses started bundling subscription services with "setup fees" or other professional services. The benefit here is that a setup fee or consulting service is delivered immediately, and the revenue from them can thus be recognized immediately. Expanding on this idea, some businesses would sell a "package" of subscription and professional services.
Acme Corp starts selling the "White Glove Service Package." They offer to configure their inventory tracking software for your use so you can start tracking your inventory more quickly. For $1000 per year, your business gets access to the software and these configuration services. Because we know how Acme Corp started pricing their software, we know that the value of the subscription is $899.99, and the value of the configuration services are $100.01.
Some companies have tried to aggressively recognize revenue by saying the bundle pricing split was really $900 of services and $100 of subscription. This would allow them to recognized $900 immediately for the services, and only defer $100 over 12 months for the software. To counter this, FASB now enforces rules for "Vendor Specific Objective Evidence" or VSOE, for bundle pricing. This requires companies that sell software and services together to track "objective" prices for each component of the bundle. When these items are all sold in a bundle, the total revenue of the bundle must be recognized in proportion to each component's relative contribution to the total price by comparing all the components' objective prices.
In this Acme Corp example, if we know the "objective" price of the software subscription is $900, and the "objective" price of the services is $100, then we know there is a 9:1 ratio between the two. If a sales rep cuts a special deal for a large customer and sells the bundle for $500, we can thus still figure out how much of that $500 should be deferred and how much can be immediately recognized (.9 * 500 = 450 must be deferred and .1 * 500 = 50 can be immediately recognized).
There are other, more specific and complicated splits, such as EITF 08-01. This relates to companies selling a combination of hardware, subscriptions, and services. Think of this as an extension of the VSOE bundled pricing above. However, businesses might not yet have an established VSOE price for the components, and as such a more complex calculation is required to ensure the sales price, discounting, and rev rec of each component falls at least within consistent boundaries, if not adhering to specific objective evidence for pricing.
How do businesses implement deferred revenue and revenue recognition?
The approach to managing this accounting side of the business depends greatly on the scale of the business and the complexity of the scenarios. Check back soon for my post on subscription businesses for examples that can significantly ratchet the complexity of a business's revenue recognition requirements.
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 to track their deferred and recognized revenue. These can range from simple to complex, depending on the business requirements. 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. These solutions generally require the least up-front cost because most organizations have Excel (or similar) tool for tracking. While the up-front costs of the tools tend to be minimal, the organizational costs of maintenance, visibility, and manual entry tend to be significant.
- Stand-alone rev rec software: Some companies will choose to create sales and rev rec schedules in an external, standalone tool built specifically for managing revenue recognition. The output is generally the journal entries to be entered into the accounting/ERP software, either manually or via an import. These tools solve many of the issues with excel, but only partially bridge the gap to the company's financial statements.
- Integrated rev rec software: Some accounting packages (NetSuite, 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. These systems tend to be on the upper end for cost, but provide the greatest capabilities. As a result, a business using an ERP package in this way can report on the balance of their deferred revenue vs. revenue they have recognized, segment that data by customer and product line, compare with cost of good sold metrics, and mesh the results with CRM/Support data to get a picture for true profitability on their service lines.