A Generally Accepted Accounting Principle (GAAP) that specifies the conditions under which revenue is considered to be recognized and reported.
Revenue Recognition: The moment of truth that defines real revenue
Often times, we come across a scenario where business claim their revenue is $x, and sometimes this is simply based on a sale they made. Or they’d have claimed their MRR or ARR as recognized revenue. It’s a common misconception.
When, in fact, it is not revenue till (i) you have rendered all the services defined in your contract with your customer, and (ii) there is a reasonable certainty with respect to the amount you receive for those services. You recognize revenue only when these two conditions are met.
With the subscription model, your business is liable to service the customers over the duration of their relationship with your business. And if any of the obligations that you had committed to does not get satisfied, there’s a chance they’ll cancel mid-way and you have to issue a partial refund. Or perhaps they find more value in upgrading to a higher plan in the midst of service delivery. Toss in a discount for a month’s upgrade. With so many possibilities, accurate revenue recognition becomes even more tricky.
Why is Revenue Recognition important after all
With everything moving from one-time perpetual license model to a subscription model, this definition is particularly important. Primarily, that is because the success of the business does not depend anymore on how many software are sold, but instead, on the customers’ experience in using the product on a recurring basis. With the perpetual license model, you recognize revenue on delivery, as opposed to recognizing revenue over the duration of the customer’s relationship with your subscription business.
How you recognize revenue impacts several critical aspects of your business. Some of them include:
Valuation of your company based on historical revenue performance
For payments that involve annual payments or prepayments, it’s important that you don’t recognize the prepayments as sales already, as the customer may ask for a refund at any time for the unused period. To accurately park this under the correct accounting head, you should show this amount under liability instead of sales.
The payment that is collected upfront is, then, deferred. It means, whenever an invoice is raised, you would route it through the Deferred Revenues, which helps point out the pending revenue to be recognized for the rest of the subscription period.
Let’s assume that John is a customer who has signed up with your product. John opted for the annual Pro Plan priced at $12000 per annum starting from the beginning of January. The revenue recognition, in this case, is fairly straightforward.
John gets billed with an invoice of $12000 upfront at the beginning of January. Of this, $1000 gets recognized in January whereas the remaining $11000 is placed in Deferred Revenue
The subsequent month, at the end of February, another $1000 gets recognized for the services rendered by your product and this goes on, till December, when your product recognises all of the $12000 paid by John and the Deferred Revenue Account holds nil balance.
This calculation changes based on subscription scenarios such as plan-based upgrades & downgrades, quantity-based upgrades and downgrades, cancellations, etc.
More reads about how you should perceive revenue recognition for your subscription business