While the recurring revenue that comes with subscription-based businesses can add stability, it can also add complexities if you frequently have customers making one large annual payment at a time for monthly services.
Revenue recognition helps you properly account for those services and evenly distribute those payments to align with the reporting period. Many growing businesses skip this step, resulting in inflated revenue numbers that don’t accurately reflect the services they’ve performed for a specific point in time.
What is revenue recognition and why does it matter?
Revenue recognition is a generally accepted accounting principle (GAAP) that dictates when and how a company should record its earnings for goods and services to customers.
For a brick-and-mortar store, this is easy: you receive revenue as soon as a customer pays at the cash register and takes home their purchase.
With subscription billing, it's not as straightforward. Software-as-a service (SaaS) businesses, for example, often charge annual rates. For these companies, accounting standards codification (ASC) 606 dictates that revenue should be recognized when (or as) your company meets its performance obligations.
If a customer signs a $12,000 contract on June 30 for an annual subscription to your marketing software beginning in July, it would not be GAAP-compliant to recognize that entire $12,000 as July revenue. Instead, you should recognize revenue of $1,000 for July, because at that point your company has only met one-twelfth of its performance obligations to that customer.
Why worry about revenue recognition?
Aside from the fact that not following the revenue recognition standard is poor practice and can result in action from the SEC if you're a public company, there are plenty of reasons why proper revenue recognition is necessary.
Decision-making
Improper revenue recognition equates to counting your chickens before they've hatched.
If your company signs an annual contract and records the full $12,000 as the amount of revenue, then immediately spends it to attend a conference for your sales team, you’ve spent money you haven’t actually earned. If that client cancels their agreement or goes out of business a few months later, you’ll have a shortfall.
Recognizing revenue properly leads to better planning.
Investor and loan reporting
Investors and creditors like to see companies that are growing steadily and sustainably. If a line graph on your annual financial statement looks like a mountain range, with a huge jump in revenue one month and a steep drop the next, that may be taken as a signal that income is unstable and you're not ready for growth. Recognizing revenue according to ASC 606 means you'll show a steady income each month, making your company more attractive to investors and banks.
Revenue recognition is all in the tools
To recognize revenue according to ASC 606 and the Financial Accounting Standards Board (FASB), you need the right accounting software. Many companies rely on spreadsheets to do this, which creates several critical issues. Here are some of the most common ones:
Room for error
Entering data manually into a spreadsheet, especially when dealing with many moving parts (Customer A began their annual contract in September at a promotional rate; Customer B signed up for their subscription in November; Customer C just canceled …), provides plenty of opportunity for error. If you enter the wrong subscription rate or copy the wrong formula, you can end up with a string of errors that repeat over and over. The more contracts you have, the more complex things become.
No audit trail
When an error inevitably occurs, spreadsheets leave you with little recourse. If a customer cancels their subscription halfway through their contract period and your team erroneously deletes the entire row pertaining to that customer, you've lost record of the money they already paid. If you're lucky, you may be able to catch the mistake quickly and piece the information together again. If you're not so lucky, you'll learn of the error when the numbers won't reconcile at the end of the accounting period.
Having multiple team members using the same spreadsheet without tracked changes also makes it impossible to see who has changed the data, which could result in embezzlement.
Manual data entry
Revenue recognition can be a tedious process if your accounting team has to copy and paste the same data over and over to spread payments out throughout the year each time you have a new customer. This wastes time they could be spending on higher-value priorities, such as forecasting and budgeting.
Legacy software isn't the answer
Generally, when your business grows past the point where spreadsheets are a viable option for tracking financial data, the next step is to invest in dedicated accounting software such as QuickBooks or Xero. Both of these solutions carry features such as income and expense tracking and more.
Unfortunately, neither QuickBooks nor Xero offers revenue recognition as a feature, so the only way to recognize revenue in the proper time period is through a series of workarounds that might end up even more complicated than a spreadsheet. That doesn’t mean your only other option is to invest in a costly ERP software that has more features than your small-to-medium-sized business could possibly use.
Gravity solves your revenue recognition quandary
With Gravity Software, you don't need to make any of these compromises. Gravity is a cloud-based accounting software designed especially for multi-entity companies.
With Gravity's revenue recognition module, you can:
- Create manual or automated deferral schedules through invoices
- Recognize revenue on a monthly, quarterly or annual basis
- Choose at what point in the accounting period the revenue is recognized
The module is offered separately as an advanced functionality, just in case your business isn't doing subscription-based business yet.
Learn more about how Gravity Software can take care of all your subscription billing and revenue recognition needs. Schedule a demo today.
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