Today’s subscription-driven economy poses a formidable force, forecasted to reach a market size of $1.5 trillion by 2025. Subscription-based companies outpace the growth of S&P 500 companies by up to 3.7 times.
This impressive performance justifies subscription businesses’ positive outlook and excitement over potential revenue growth, right? But hold off on your excitement for a moment; let’s talk about your subscription accounting method.
As a subscription-based business, your accounting practices differ from those of traditional businesses and must comply with the ASC 606 requirements. ASC 606 governs how you recognize customer revenues and report your financials.
In this guide, we dive into subscription revenue accounting to help you ensure accurate revenue recognition and sound financial health.
Understanding Subscription Revenue
Subscription revenue is the money generated by charging customers a recurring fee at regular intervals (e.g., monthly, quarterly, or annually). Streaming services like Netflix and Hulu rely on subscription revenue, as do most software-as-a-service platforms used in B2B environments.
This recurring revenue represents a crucial metric for subscription-based businesses, influenced by the number of customers, customer retention rate, and subscription fees. Your selected subscription model also directly impacts your revenues.
Types of Subscription Models
Several subscription models are available for your business, and your pick depends on current industry trends, type of offering, target audience, and scalability. For instance, consider:
- Fixed vs variable subscription fees: Fixed fees mean customers pay a flat rate for access to a product—a Netflix or software subscription is a good example. A variable fee changes based on demand or customer behavior—this is ideal for travel or ride-sharing services.
- Recurring vs non-recurring revenue: In a recurring model, you charge customers at regular intervals (e.g., monthly or annually) for continued access to your service. In non-recurring models, customers make a one-time payment for access to your service for a set period.
Fixed and recurring models suit services that offer ongoing value, such as content access, memberships, and software. Variable and non-recurring models work best for one-time products or experiences, like event subscriptions and product bundle purchases.
Revenue Streams in Subscription Businesses
Subscription-based businesses boast varied revenue streams to ensure steady cash flows and drive profitability. Subscription fees comprise their primary revenue source and provide a predictable cash flow.
Instead of one plan, tiered pricing (e.g., multiple subscription levels like basic, standard, and premium plans) allows you to still cater to various customer segments and maximize revenue through upsells and renewals.
In-app purchases offer another avenue for increasing your revenue—like charging customers for access to premium content or features. If you offer software, diversifying your revenue streams with services like installations, support, and integrations can maximize revenue.
Key Principles of Subscription Revenue Accounting
As a subscription business, your revenue accounting must be accurate, compliant, and reflective of your financial health. To that end, you must follow ASC principles.
Revenue Recognition Standards (ASC 606)
Accounting Standards Codification 606, or ASC 606, is a revenue recognition principle that dictates how companies recognize revenues. Under this framework, firms can only recognize revenue when customers obtain control of products or services. It provides five steps for revenue recognition:
- Identify the contract: Define the criteria for entering a contract with a customer to deliver services or goods.
- Identify the performance obligations: The contract must detail the company’s performance obligations, such as promises to transfer goods and services to customers.
- Determine the transaction price: Calculate the price the business will receive from the customer per the contract, including cash and non-cash compensations.
- Allocate the transaction price: Distribute the total transaction price across all the performance obligations in the contract. As a subscription business, the performance obligation is continuous, making allocation complex but vital.
- Recognize revenue: Companies can ONLY recognize revenue after fulfilling each unique performance obligation in the contract.
This revenue recognition standard also requires companies to disclose information about their revenue streams. This ensures transparency, integrity, and easy access to a company’s financial statements.
Matching Revenue With Performance Obligations
ASC 606 mandates matching revenue with each distinct performance obligation and allocating the transaction price accordingly. You must also document obligations, including the dates for obligation fulfillment and the corresponding revenue.
In a subscription business model, the performance obligation is continuous—a contract where an entity delivers goods or services over a subscription period. In this case, revenue recognition for obligations occurs progressively with service delivery.
For instance, if a customer picks an annual plan at $20 monthly, you must attribute each month’s payment to its respective accounting period. You can’t recognize the fees as a lump sum during the contract period.
Deferred Revenue
Also known as unearned revenue, deferred revenue refers to advance customer payments for future product or service delivery. In a subscription business, a notable example is when a customer pays for an annual subscription upfront.
In this case, your subscription accounting method only recognizes the revenue upon you earning it. Until then, you can’t report deferred revenue on the income statement. Instead, report them on the balance sheet as a liability.
Additionally, it becomes important to distinguish short-term vs. long-term deferred revenue as a part of any subscription businesses. This reclassification is a requirement in ASC 606, so it is imperative to understand the implications of invoicing for any period greater than a single year and how you may need to adjust your balance sheet accounts to reflect the long-term nature of such contracts.
Revenue Recognition Challenges in Subscription Accounting
Usually, revenue recognition affects a company’s financial health and tax obligations. Subscription businesses face even more challenges, such as complex contracts, customer churn, and recurring billing cycles. Here’s how to address them.
Handling Complex Billing Scenarios
In high-volume subscription businesses, there’s a risk of misaligning the timing of revenue recognition when handling deferred revenue accounts. This is because you can’t recognize the revenue until you fulfill the contract obligations.
Proper record-keeping and deploying a revenue recognition software solution can address this challenge. The right subscription revenue recognition software and management tools provide automated revenue recognition capabilities, preventing premature recognition and entry errors common with manual calculations.
Also, establish a clear strategy or policy for discounts, free trials, promotions, and contract modifications. Ensure transparency by accounting for these variable considerations and amortizing the reduced revenues across the full contract period.
Managing Customer Cancellations and Refunds
Refunds and cancellations force businesses to reverse any previously recognized revenue. When this occurs, you must update your records to account for the revenue loss and maintain accurate financial statements.
A clearly defined and transparent refund/cancellation policy reduces the accounting burden on your team. For example, your policy can state that customers are eligible for a 50% refund if they cancel their subscriptions within the first six months.
Tools and Best Practices for Accurate Subscription Revenue Accounting
Subscription revenue accounting presents myriad complexities for accounting teams. Variables like discounts, cancellations, refunds, and free trials complicate revenue recognition, which gets even more overwhelming with manual processes. On top of these, many subscription businesses bundle various products and services which may result in a need to break-down that bundle into its individual elements while also simultaneously applying a strict stand-alone selling price policy to ensure revenue is equally allocated/distributed to each obligation.
But these complexities don’t need to create cause for concern—embrace revenue automation to streamline your processes, prevent errors, and ensure accurate reporting.
That’s where RightRev comes in. It offers an advanced revenue automation solution to simplify the process and ensure ASC 606 compliance.
RightRev empowers businesses to tackle the complexities of revenue recognition, such as high volumes, contract modifications, reporting, SSP calculation, and data connectivity. It automates revenue recognition processes for easy access to real-time revenue data and faster book closures.Companies like Brightly, Drata, and Decebo rely on RightRev to automate revenue recognition and comply with standards like ASC 606 and IFRS 15. They leverage our ASC 606 software to process large amounts of revenue data and contract changes, close books faster, and gain accurate revenue insights.
Best Practices for Managing Subscription Revenue
Managing subscription revenue effectively is essential to comply with accounting standards, ensure a steady cash flow, and improve stakeholder confidence. Here are some best practices:
- Implement revenue recognition software to automate revenue tracking and optimize pricing and subscription billing models
- Review and update your revenue recognition policies as your business evolves to adapt to new circumstances and changing accounting standards
- Ensure continuous monitoring of performance obligations through regular reconciliations, independent reviews, and segregation of duties
- Ensure accurate and timely reporting by keeping detailed contract records, automating manual processes, and implementing internal controls
Employees should also receive comprehensive training to ensure the consistent application of revenue recognition policies across the organization. All employees must adhere to the same rules and principles to avoid discrepancies and inaccurate reporting.
Automate Subscription Revenue Accounting With RightRev
Regardless of your subscription model, accurate revenue recognition is essential. It provides a clear picture of your actual revenue, deferred revenue, and liabilities, allowing you to assess profitability, plan cash flows, and ensure accurate statements.
While recognizing subscription revenue can be complex, RightRev’s advanced revenue recognition solution simplifies the process and facilitates access to actionable data for revenue forecasting. RightRev empowers accounting teams.
With RightRev, you can automate all your use cases, including reporting, contract modifications, complex arrangements, SSP analysis, and high-volume operations. Our advanced solution automates recognition based on your rules, such as upon booking, delivery, billings, and more.
With RightRev you can embrace subscription revenue accounting confidently. Request a demo or contact us today to learn more about how automating revenue recognition works and discover how RightRev can streamline and automate your subscription revenue accounting.
