Subscription revenue recognition has evolved in line with the advent of modern billing models introduced by the growth of subscription services. The ubiquity of subscription billing has led to many SaaS companies scrambling to understand best practices when it comes to revenue recognition.
While complicated to manage, these less traditional billing models can be very beneficial for companies looking to maximize their revenue and capture new markets with competitive subscription strategies. Understanding how to recognize revenue from these models is critical to their success and it can feed into every aspect of the company’s financial health. It’s a mistake to assume that only the finance teams need to understand how it works. Most companies will need to get numerous departments involved so they can evaluate their contracts, strategies, key performance metrics, planning, budgeting, pricing strategies, and even IT requirements.
In this blog, you’ll learn all about revenue recognition and get access to useful resources to help you better understand the complexities of “rev rec” for recurring billing and the accounting standards that you will need to meet (i.e., ASC 606 and IFRS 15). Below is a list of the topics covered. You can click each one to jump ahead to that section:
- Defining subscription revenue
- What is subscription revenue recognition
- Understanding accrued versus deferred revenue
- Why revenue recognition is important for subscription billing
- Examples of how to recognize revenue for subscriptions
- When should subscription revenue be recognized
- Deferred revenue for subscription billing
- Bundles for subscription revenue recognition
- The introduction of ASC 606 and IFRS 15
- 5-step process for revenue recognition
Defining subscription revenue?
Subscription revenue refers to the income generated from ongoing subscriptions to a product, service, or platform. It represents the revenue stream that a business receives on a regular basis from customers who have subscribed to their offering for a specific period. This revenue is typically recurring, predictable, and often collected at regular intervals, such as monthly or annually. Subscription revenue is a key metric for subscription-based businesses and is influenced by factors such as the number of subscribers, subscription fees, and the retention rate of customers.
This type of revenue is frequently accompanied by enhanced customer retention, particularly when subscribers are required to actively cancel their subscriptions to discontinue the service. By subscribing, clients can anticipate their expenses over the subscription term and allocate funds accordingly. The revenue acknowledged by the company should align with the performance obligations, which are the services agreed upon with the client in exchange for the subscription fee.
What is subscription revenue recognition?
It is a generally accepted accounting principle (GAAP) referring to how you recognize revenue. Regardless of when money lands in an account, the revenue only counts when the product or service is delivered and accepted. It helps companies identify what is actual revenue and what is a liability and should be deferred revenue.
In more traditional business models, the difference between cash collection and revenue recognition is often subtle, delivery of the product happens at the time of the transaction. For SaaS companies, it’s not so simple. Revenue should be recorded depending on how it accrues over time. You should only ever recognize revenue when the entire revenue-generating process is complete i.e., you must not recognize revenue until the contract’s performance obligation has been met and accepted.
Subscription revenue recognition is a subset of overall revenue recognition. It involves recording income once the entire revenue-generating process is complete and the performance obligation outlined in the subscription contract has been fulfilled and accepted by the customer. This shift in recording revenue impacts how subscription-based companies account for their financials, moving away from capturing a one-time lump sum payment and considering the subscription term as an essential component of their accounting practices.
Understanding accrued versus deferred revenue
Accrued revenue and deferred revenue are two distinct concepts within subscription revenue recognition. Accrued revenue refers to recognizing revenue for performance obligations that have been fulfilled but not yet billed, while deferred revenue involves deferring subscription revenue for cash received but not yet fulfilling all performance obligations.
Why revenue recognition is important for subscription billing
Revenue recognition is of utmost importance for subscription billing due to several key reasons. Firstly, it ensures that accounting records are accurate and up to date in real-time. By properly recognizing and accruing revenue as performance obligations are fulfilled, companies can maintain accurate profit and loss margins that reflect their actual revenue.
Moreover, revenue recognition plays a vital role in connecting actual revenue and expenses concurrently, providing companies with a clear understanding of their financial health and identifying which subscriptions or activities are truly profitable. This visibility into subscription revenue recognition impacts every aspect of the business, allowing for informed decision-making and resource allocation.
Accurate revenue recognition is particularly crucial when it comes to external factors such as seeking investments, going public, or securing business loans. To attract investors and maintain transparency, companies must accurately recognize and defer revenue on their financial statements. Failing to grasp the intricacies of revenue recognition can have detrimental effects on the company’s reputation and its ability to make sound financial decisions.
Additionally, revenue recognition is essential for corporate tax calculations and compliance. The introduction of accounting standards such as ASC 606 and IFRS 15 has helped SaaS companies gain a better understanding of revenue recognition practices and the necessary steps to ensure compliance.
Examples of how to recognize revenue for subscriptions
In order to gain a comprehensive understanding of how revenue recognition works for subscription-based businesses, let’s explore four different examples of subscription strategies and how revenue would be recognized in each situation.
These examples provide a simplified depiction of revenue recognition principles for subscriptions. However, it is important to note that implementing revenue recognition can become complex, especially when managing multiple revenue models.
The specific method of revenue recognition will depend on various factors, including the terms outlined in your contracts, the performance obligations involved, and the accounting standards that your company is required to adhere to.
Example 1 | Monthly subscriptions
Consider a content streaming platform as an example. Typically, these companies recognize revenue on a monthly basis. If a subscriber pays $15 per month for their subscription, you would record $15 in revenue each month on your financial statements for the duration of the customer’s subscription.
Example 2 | Annual subscriptions
There are companies that offer annual subscriptions (often at a reduced rate for the commitment). A good example might be a software license. Revenue is recognized over the entire subscription period. If a customer pays $240 for an annual plan, you would divide the full amount by twelve months and, recognize $20 in revenue each month.
Example 3 | Multi-year subscriptions
Similar to annual subscriptions, businesses may choose to provide longer-term contracts that recognize revenue throughout the contract duration. Suppose a customer signs a three-year deal for $576. In this case, you would recognize $16 in revenue each month over the course of three years, you arrive at this number by dividing the total revenue by the number of months over which the revenue will be recognized.
Example 4 | Usage-based subscriptions
With usage-based subscriptions, such as cloud computing or pay-as-you-go services, revenue recognition may be based on the customer’s usage or activity. Let’s say a customer utilizes cloud storage at a rate of $1 per GB. If they were to use 500 GB in one month, the company would recognize $500 in revenue.
When should subscription revenue be recognized
Determining the appropriate timing for recognizing subscription revenue is a crucial consideration for subscription-based businesses. Revenue should be recorded on an accrual basis, meaning it is recognized when the value is earned, rather than when payment is received. However, the complex nature of subscription models, where products and services are provided over different time periods, can complicate the recognition process.
Timing of subscription revenue recognition
At the time of payment
- Common for one-time purchases or features.
- Revenue is recorded immediately as the customer takes possession of the product.
- Recognized in the same accounting period as the payment.
Before payment is received
- Typically applicable to service-based businesses.
- Revenue is recorded after product delivery but before payment.
- For example, service provided in June is recorded in June financial statements, even if payment is received in August.
After payment is received
- Subscription-based businesses deliver products or services repeatedly over a fixed period.
- Revenue is gradually recognized as services are provided, even if payment is received upfront.
- Recognized over the service delivery period.
Prepaid subscriptions
- Long-term prepaid subscriptions (e.g., annual plans) should not have revenue recognized upfront for the entire amount.
- Revenue is recognized gradually over the subscription period, aligning with performance obligations.
- Deferred revenue moves to recognized revenue incrementally.
Deferred revenue is key to financial health for subscription billing
You earn revenue for a service each day that you deliver that service. If you claim the unearned income, it can lead to tricky situations if customers decide to complain, cancel, or ask for refunds. Deferring revenue appropriately makes it a liability and will protect your cash flow, preventing you from investing more than you earn.
Traditionally speaking, companies didn’t need to defer much of their revenue. Goods were usually paid for and received over the counter. Buying software was as simple as purchasing a disk and then downloading the content onto your hard drive. The customer had ownership of the product and might wait for years to update the technology.
In our current world, technology is advancing at an accelerated rate. Software no longer takes years to update, and by hosting services online and selling subscriptions. SaaS companies allow customers immediate access to the latest updates and configurations.
Companies are establishing recurring billing relationships that are mutually beneficial. However, this does complicate revenue recognition for the software or subscription provider. Customers may pay for services or software in advance, but you can only recognize revenue as services are delivered. For instance, if a customer buys a yearlong subscription and pays upfront. You are obliged to defer most of that revenue (as it is a liability rather than an asset) and recognize the revenue throughout the year.
Bundles bring further complications to revenue recognition for subscription billing
SaaS companies often struggle to understand revenue recognition for services sold in bundles. Sometimes, a new customer will pay for several features at once. It’s common to have consulting services, set-up fees, customization, and support services included with the initial purchase of software.
Some of these services may be optional (e.g., consultancy services). Others might be obligatory (e.g., set-up fees). Revenue recognition is determined by whether or not these services are separate units of accounting.
An example of rev rec for separate units of accounting in a bundle:
- The software for an annual fee of $5,000
- An obligatory set-up fee of $400 for customizations and instalment
- $1,000 for consultancy services over the first three months of the purchase. This is optional and could be purchased separately.
In this instance, you should recognize the revenue of the set-up fee and annual fee over the first year of the service. Though the set-up fee is delivered early in the contract, it’s obligatory. Therefore it is part of the same unit of accounting as the subscription fee.
In contrast, the consulting service can be bought separately. It is a separate unit of accounting. Recognize the revenue over the first three months as the delivery of the consultancy services occur.
The introduction of ASC 606 and IFRS 15
The growth of subscription services led to the introduction of ASC 606 and IFRS 15 by the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB). These standards help SaaS companies better manage their revenue recognition. As a result, enabling them to stay consistently compliant. They created a five-step approach that can be applied to any subscription billing structure. It outlines how to correctly recognize revenue with any contract.
The 5-step process for revenue recognition for SaaS
- Identify the contracts with a customer.
- Identify the performance obligations in the contracts.
- Determine the transaction price.
- Allocate the transaction price to the contract’s obligations.
- Recognize revenue as you satisfy the relevant obligations.
There’s a lot to learn in each of these steps, which is why we created a booklet to help you better understand each stage and how they apply to your company. You can download it for free below. Start to recognize revenue correctly and enable your company to reach its full potential.
