As a business owner, it’s important to understand how to recognize subscription revenue. This guide will teach you the best practices for doing so. I remember when I first started my business, I had no idea how to properly recognize this type of income. It wasn’t until I spoke with my accountant that I realized just how important it was.
By following these best practices on how to recognize subscription revenue, you can ensure that you have an accurate bottom line.
How to Recognize Subscription Revenue
There are a few key ways to recognize subscription revenue. The first is to look at the company’s sales model.
If the company sells access to a service or product on a subscription basis, then subscription revenue is likely a key metric for the business. The second way to recognize subscription revenue is to look at the company’s financial statements.
In particular, look for line items labeled “recurring revenue” or “subscription revenue.” This will give you a clear picture of how much revenue the company is generating from subscriptions.
Finally, you can talk to the company’s management team to get a better understanding of how they view subscription revenue and what role it plays in the business.
What is Revenue Recognition?
Revenue recognition is the process of recognizing revenue by reporting the monetary value of a transaction or contract over a period of time. The method of allocation and the period is determined by rules, guidelines, and findings from organizations such as the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC).
In other cases, however, the accounting of revenues can be more complicated. Some companies deliver products to customers over time, such as software-as-a-service (SaaS) providers.
These companies have immediate revenue streams.
Other companies that deliver their services over a period of time, such as subscription-based companies like Netflix, must recognize revenue incrementally throughout the service delivery. This is because these companies provide their services continuously over a set period of time, rather than all at once.
Revenue recognition can be complex for B2B companies, especially when they offer bundled services, subscription-based support, or non-standard functions and capabilities. This is often due to customer acceptance criteria like “out clauses.”.
As a result, regulators and standard boards have implemented complicated rules to govern how all businesses should recognize revenues. These regulations were put in place to prevent corporations from inflating their earnings by recognizing income prematurely.
Subscription Revenue Recognition
The direct cost of making and selling a product is called the Cost of Goods Sold or COGS.
In a traditional retail model, the materials, packaging, and delivery costs are all considered COGS.
In a SaaS company, where there isn’t a tangible product, this is a little more difficult.
The most direct way to view it is to consider the expenses that are essential to offering this service to your client.
Paying those monthly bills is the cost of doing business, so they’re COGS.
For some companies, this could include the cost of hosting the customers’ platforms, providing ongoing support for existing clients, or paying the merchant processing fees to accept credit cards.
Non-direct expenses like research and development, marketing, and sales would not be considered COGS for software as a service.
How to Calculate Subscription Revenue
There are many ways to calculate your recurring revenue and each method has many different variations. Let’s take a look at some of the main methods.
1. Annual Recurring Revenue (ARR): This is the most common way to calculate subscription revenue.
This metric is ideal for customers who have been with the company for a long time and are either paying upfront for a contract that lasts more than 12 months or paying monthly with a contract in place that will last at least one year. This allows companies to get a more accurate idea of how much revenue they can expect to receive from these customers on an annual basis.
Let’s take a look at these examples of subscription services:
If you have one customer with a two-year contract valued at $12,000, then the ARR for that client is $12,000/2 = $6000.
If you have 20 customers each paying $1000/month, then you need to multiply the 20 by $1000/month to get your total monthly income of $20,000. Then, multiply by 12 to calculate your total ARR: $20,000 × 12 = $240,000.
Calculating ARR can be complicated if customers can change their payment amounts.
2. Monthly Recurring Revenue (MRR): This metric shows how much money customers pay in monthly recurring fees. The calculation is the same as ARR except it’s for 1 month.
Let’s take a closer look at the same examples we used above.
Divide by 24 for the number of months of the contract: $12,000/24 = $500.
Calculating your Monthly Recurring Revenue (MRR) and Annual Recurring Revenue (ARR) allows you to adjust your revenue projections as customers upgrade or downgrade their subscription plans.
When choosing which metrics to track, it is important to consider all of the different versions of each metric. For example, net MRR might be a better option depending on your needs.
3. Lifetime Value (LTV): Lifetime value is the amount of money you can expect to make from a customer over their entire lifetime. This helps you determine how much you can afford to spend on acquiring new customers.
To calculate LTV, you’ll need to know the average length of time your customers use your service before ending their contract.
Let’s consider an example where the average lifetime is 10 years and assume the following:
The customer pays $12,000 for each two-year contract, so their LTV is $12,000 × (10/2) = $60,000.
The customer pays $1000/month so the LTV is $1000 × (12 ×10) = $120,000.
LTV can be misleading because it requires the estimation of churn.
Tracking all the various metrics to maximize your revenue from existing customers, from new customers, and up-selling and cross-selling to current customers is tricky.
If you’re looking for a way to better understand your subscription revenue, Baremetrics is a great option. Their free trial allows you to get started quickly and easily, so you can get the data you need to make informed decisions about your business.
Best Practices in Revenue Recognition
Use the ‘Deferred Revenue’ metric as a comparison against your ‘Actual’ metrics to minimize the impact of any fluctuations.
Every month, set off your bad debt expenses against your revenues to recognize a more accurate picture of your true financial position.
You can deduct any discount amounts from revenue on your reports to accurately show ‘net’ sales figures.
Know how revenues and Deferred Revenues are distributed across different channels. This can help inform decisions.
Comply with any financial regulations required in your industry to ensure that you’re always transparent in your reporting.
By following the best practices for how to recognize subscription revenue, you can ensure that your business is correctly accounting for this type of income. By doing so, you’ll be able to make more informed decisions about your finances and better understand your overall financial picture.