Understanding Revenue Recognition for Subscription Businesses

Understanding Revenue Recognition for Subscription Businesses IFRS 15 promises to shake up the prevailing practices in revenue recognition across the globe. Carola Ingegnieros deep dives into the new financial reporting standard and studies its impact on subscription businesses.


Revenue recognition (or ‘rev rec’ for accountancy folks) is one of the financial metrics that companies track. The more significant the volume of business, the more stressful it is to manage, and recent changes in regulation have compounded this problem.
 

How have companies traditionally recognised revenues?


‘Rev rec’ has varied greatly across industries due to the evolution and enlargement of revenue sources throughout the business lifecycle. For example, selling technology in the software world has evolved from selling packaged software to selling access to services. From a monetisation perspective this means that new business models are expanding, namely: subscription plans, including “freemium”, pay-per-use and outcome-based models. Clearly, they all differ significantly from the ones used by more traditional businesses that rely on one-time charging models.

As more businesses move to subscription models, how they recognise upfront payments for services delivered over time becomes critical to the financial health of the company. As a result, governments are catching-up by introducing rules on how this is to be done.

It is not surprising that IAS 18 Revenues and IAS 11 Construction Contracts will be superseded by IFRS 15 Revenue from Contracts with Customers. The new standard, in fact, is meant to improve the global financial reporting of revenues and its comparability by portraying the nature, amount, timing and uncertainty of revenue and cash flows arising from a contract with a customer. As it is one of the most important measures to evaluate a company’s financial performance it is crucial for investors and analysts that companies adopt standards, and equally important for the companies that they adapt quickly to the new requirements.
 

What requirements come in IFRS 15?


How?

According to the general rule applied by IFRS 15, companies must recognise revenue to represent the transfer of promised goods or services to customers in line with the amount to which they expect to be entitled in exchange for those goods, excluding amounts collected on behalf of third parties (e.g. sales taxes).

When?

Opposite to the previous “risk and rewards approach” (from IAS 18), revenues must be recognised when the customer obtains control of the good/service (“control principle”).

The standard itself sets out the core principle that a company shall apply to recognise revenues through the five-step model, as referenced by Deloitte below:

deloitte-nl-risk-data-architecture-ifrs15.jpg


For a better understanding of the topic, the e-learning tool made available by Deloitte is another useful resource.


How will IFRS 15 affect businesses?


The clock is ticking and the effect of IFRS 15 is extensive, as all industries may be impacted by the way they go about doing their accounting, from EBITDA to their underlying support systems and processes.

Some companies will see widespread changes (where certain sectors have specific guidance included in the new standard) considering the type of contracts and transactions and the current accounting policies embedded in each company.

This means that IFRS 15 will not be such a big deal for companies with revenue streams from a consumer retail business, whilst the impact on companies engaged in the B2B segment with multi-year contracts can be extensive. In today’s world, revenue is not always tied to cash and no one knows it better than modern tech companies who often rely on subscription-based business models for revenue.

Some of the main implications arising for companies will be:
  • how to assess performance obligations (PO): as a good/service (or bundle) that is distinct (single PO) or as a series of distinct goods/services that are substantially the same and have the same pattern of transfer (not small individual POs); regarding software companies this will involve evaluating mainly the following items: software license, installation, software updates and technical support.
  • revenues “over the (e.g. continuous transfer)1 won’t automatically be recognised, as they will be as the PO is satisfied;
  • companies will have to adjust revenues for advanced/deferred customer payments;
  • there won’t be many different methods to measure contracts development;
  • “margin smoothing” and net value for each contract won’t be allowed anymore;
  • modifications of contracts only affecting the transaction price will be accounted for prospectively if the remaining goods or services are distinct or on a cumulative catch-up basis, but no retrospective adjustment will be required;
  • a specific guidance about variable considerations will be provided.
In particular, companies that manage SaaS agreements will have to face sector-specific revenue rules, as they will deal with frequent upgrades/downgrades as well as usage-based revenue recognition that imply advance payments and overage charges. They will also have to take into consideration the amortisation of the upfront fees and the fact that most arrangements will require the allocation of services with standalone value in turn imply reporting specific requirements for Monthly Recurring Revenue (MRR) and Annual Recurring Revenue (ARR). All this comes from the fact that ‘rev rec’ is independent of billing.
 
Companies must therefore evaluate how the brand-new model will affect their business activities, and not just in terms of accounting policy. It is likely that the most structured ones will have to revisit the format of their sales deals and contract negotiations; their go-to-market strategies; their key business metrics; their planning, budgeting and controls processes; and not to mention their IT requirements.

Unlike other new standards, IFRS 15 requires not only accounting attention, but also impacts many other aspects of a business and little will go untouched.
 

What are the challenges businesses might face with their current IT systems?


Most of the problems will be in two areas: capturing the necessary data which is later used to recognise revenue; and moving this data between the different finance systems.
Examples of this are:
  • the inability to configure and compare the frequency and recurrence of payments vs the delivered service and the contract length;
  • how the service is managed after contracted periods expire (e.g. “evergreen” services);
  • the automatic progression of services from trial and freemium to fully chargeable;
  • configurable output from the Product Catalogue(s), Accounts Receivable and Sales Ledger, in to the General Ledger;
  • analytics on performance, burn rate and deferred income as well as forecasting;
  • awareness of service delivery dates;
  • pro-ration of service charge values;
  • service value changes after product change.
Many of these values are either defined or captured in disparate systems. It is therefore essential to ensure that the end-to-end process has been well designed. The key data must be identified and its capture and flow-through to the accounting systems well planned. Ease of integration between the platforms managing the product definition, opportunities, sales and delivery, must be open and versatile, allowing companies to easily adapt and change those integrations as required.

In conclusion, just as SaaS is driving much of the burden of revenue recognition due to its common pricing and commercial models, it is also providing most of the solution through easy to integrate platforms, open APIs and extensible data models. An inherent understanding from those SaaS providers is required to address new ‘rev rec’ challenges. After all, subscription business models are what most SaaS vendors live on.


1 A PO is satisfied over time if one of the following is met:
- customer simultaneously receives and consumes as the supplier performs;
- customer controls the asset enhanced or created by the supplier;
- supplier does not create an asset with an alternative use and there is an enforceable right to payment


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