Revenue recognition is a key topic for subscription businesses to make sure that finance forecasting is accurate and accounting works smoothless.
What is Revenue Recognition? #
Revenue recognition is an accounting principle. If we take a closer look at the term: revenue means turnover, and recognition is also translated as ” detection” or ” identifying”. Revenue recognition is a special topic in accounting because it relates directly to the question of when a turnover was realized and in what amount. So at what time were the revenues generated by the company?
Enabling the finance team across the subscription journey #
A very necessary step to avoid the pitfalls of a complex pricing and product portfolio is a close alignment with the finance team both on a strategic and technical level.
A Bill survey from 2023 (PDF) shows that the majority of finance team leaders feel that they are more and more involved with technology investments and even take on strategic decisions in other departments (e.g., sales). No wonder, since they need to ensure that anything involving finances is fully documented, by the book and can be properly processed to ensure compliance and cash flow.
To avoid spreading finance resources too thin, smooth data processes and automation can ensure that finances are transparent and that manual tasks are reduced (which almost always reduces error rates as well).
In fact, the Bill survey states that AR software (accounts receivable) can have a huge impact on finance teams:
- Better visibility into cash position/cash flow (34%)
- Time savings in processing (34%)
- Easy report creation (29%)
- Better control (27%)
- Reduced processing costs (27%)
- Faster closing books (27%)
- Fewer errors (26%)
- Improved customer relationships (26%)
- Faster payments (26%)
- Reduced late payments (21%)
What are challenges of revenue recognition? #
The topic of revenue recognition is of great importance for the subscription business. The reason lies in the special business model. If, for example, a subscription model is started for which monthly fees of 15 euros plus VAT are charged, the question arises: When is the revenue to be recognized by the company? At the time of payment? At a certain cut-off date? And what happens if, for example, a customer books a different package or cancels? What if a different payment interval is chosen? Or the customer has a complaint and wants to cancel the entire contract?
Most subscription businesses work with customers paying upfront and then gaining access to services or products over a specific time span (or frequency). This usually results in more complex accounting compared to the usual one-time payment, where a service or product is “exchanged” directly for a payment. The complexity increases when additional one-off costs (e.g. for setup, support, etc.) or various subscription products or services (add-ons, etc.) are added.
Revenue recognition becomes relevant as soon as the time of invoicing and payment and the time or period of service provision diverge.
Example 1: A merchant writes an invoice ahead of the use of a service for the following year. The customer pays for this time frame. The merchant is now bound to deliver the service over the agreed upon timeframe (12 months). The sales revenue from this invoice are divided over the 12 months. For 12 full months, this means that every single month, 1/12 of the overall revenue is realized.
Example 2: A customer is using a service as part of their subscription. This is being billed after usage. The invoicing of this payment occurs regularly, every first day of the following month. The revenue of this usage will be assigned to the month of usage, no matter the time of the invoice.
The underlying principle of revenue recognition is explained by James from the YouTube channel “Accounting Stuff” in an easily understandable way and in just two minutes.
Another complexity arises when you add bundled services – for example the combination of one-time services or deliveries and services that last over time. For this, the services within this bundle need to be identified and the allocation of each service to the full price needs to be broken down and – depending on the type of service – periodically differentiated. This differs based on the booking standard (e.g., HGB versus IFRS 15), so different approaches to the allocation of the partial revenue on the individual periods could come to fruition.
All these questions can have an impact on the company’s sales performance. When a customer goes into a shop and buys a TV, the case is quite simple. It is quite easy to determine when the turnover has been realized. But subscription business models bring more complexity. Therefore, clear rules are needed for revenue recognition. In Germany, these rules are set by laws (e.g. HGB) and accounting standards (IFRS, GAAP).
Why is revenue recognition so important? #
First of all, for compliance reasons alone, it is important for companies to proceed correctly with revenue recognition. After all, turnover reporting is affected by revenue recognition. Companies must ensure compliance and follow the corresponding legal requirements and standard guidelines (US GAAP, IFRS).
Apart from the fact that companies are obliged to maintain proper accounting, external stakeholders, such as investors or credit institutions, are also interested in the figures. The sales revenues of a company are regularly of particular interest. For example, comparisons can be made:
- Was the company able to increase its turnover compared to the previous year?
- How high are the sales of direct competitors in the same period under review?
Of course, knowledge about revenue is also important for the company itself. Strategic decisions are made, among other things, on the basis of turnover developments.
Data analyses are indispensable, especially in the subscription business. For example, an increasing number of subscriptions can influence revenue development and thus the entire company’s growth. But in order to successfully manage the business model, decision-makers need detailed knowledge about the realization of income. Revenue recognition is a challenge, especially in the subscription business – but at the same time, it brings with it exciting analysis possibilities.
What are the revenue recognition types? #
There are various revenue recognition types known in international accounting. For example, the following revenue recognition types are common:
- Sales Basis Method: Revenue is recognized at the time of sale or delivery of the product or service.
- Installment method for revenue recognition: Proceeds are recognized using the installment method.
- Percentage of completion: Revenue is recognized by reference to the stage of completion.
- Completed contract method: In the case of long-term contracts, the revenues are only recognized upon completion of the respective project.
But which method should be used? Companies have to choose the right method so that the bookkeeping meets the requirements of accounting standards and legal regulations.
More finance insights with the CFO Trend Guide
Find current trends, regulations and challenges for finance teams and CFOs and read what you can do to streamline your processes, reduce risks and stay compliant.
What is the Revenue Recognition Principle? #
According to the revenue recognition principle, companies generate revenue when they have delivered products or provided services to their customers. The recognition does not take place at the time of the payment transaction, but when the service is rendered.
Revenue Recognition for SaaS Accounting #
Example: Assuming that 120 Euros plus VAT are due directly upon the conclusion of a SaaS contract, but the user can use the software for one year, the question arises as to how the 120 Euros are to be reported. The SaaS company has not yet (fully) provided the service at the time of payment by the user. What happens if the customer decides to change the package after 6 months? Or if the customer cancels the contract after 10 days? So the question of revenue recognition is not so simple here.
In the case of subscription business models, such as SaaS, this means that the proceeds must be distributed pro rata over the (planned) contract term. This also applies if the fee has to be paid before or at the beginning of the contract term.
Note: Important data is provided by contract management. Conditions, for example, provide a lot of information that has to be processed in accounting. But without modern technologies, the data can hardly be processed correctly and promptly. Therefore, especially SaaS providers need a software solution here that also covers the revenue recognition processes.
How does Revenue Recognition work? #
The accounting standard IFRS 15 provides a 5-step model for determining the amount and timing of revenue:
- Step 1: Identify the contract(s) with a client.
- Step 2: Identify the stand-alone performance obligations in the contract.
- Step 3: Determination of the transaction price
- Step 4: Allocation of the transaction price to the deliverables in the contract
- Step 5: Revenue recognition upon fulfillment of the performance obligations by the entity
The basis for correct data entry should already be defined in the billing system. With Frisbii, not only billing is automated. The Frisbii recurring revenue management platform supports revenue recognition methods. Deferred charges can also be formed easily on the basis of reliable data. Detailed evaluations show how subscriptions and turnover develop. Business growth can be controlled in a targeted manner in this way.
Best Practices for Revenue Recognition #
- Compliance requirements must be adhered to! Companies should be aware of the accounting standards (IFRS 15 / ASC 606) and implement them properly.
- Subscription providers should use a software solution that facilitates revenue recognition. In this way, accounting processes can be optimized and made IFRS-compliant.
- The software solution should implement the 5-step model (IFRS 15) automatically so that the accounting department is unburdened and human errors are reduced.
- Those who understand the revenue recognition principle can better align their own business model and optimize their own figures. The accounting department can thus provide the decisive data to lead the subscription business to more growth.
- Revenue recognition brings with it the difficulty that turnover identification and cash flow development are not necessarily identical. Controlling must be sensitized accordingly.
Find out how the Frisbii recurring revenue management platform can support your recurring billing and set up a meeting with one of our experts.
