Revenue recognition in subscription-based business models: The role of contract modifications & incremental expenses
While subscribers are happy to have options to customize their subscription plans, subscription businesses must learn how to handle the impact of contract modifications and incremental expenses. When subscription contracts are straightforward, revenue recognition often runs smoothly. But when there is a need to account for contract modifications like an upgrade or downgrade or how to properly allocate contracted-related expenses like a sales commission, things get can get very complex–fast.
As a recap, revenue recognition is a generally accepted accounting principle (GAAP) that identifies how revenue is recognized. When it comes to recurring revenue and subscription contracts, revenue is not necessarily recognized when payment from the subscriber is collected.
What are contract modifications and incremental expenses?
Contract modifications can take many forms, from upgrades and downgrades to pausing a subscription. It can even be as simple as a change to price, quantity, or duration. In these instances, you should be able to confidently answer these questions:
How are you going to accommodate contract modifications and incremental expenses?
Does the modification add distinct goods or services that are priced with their stand-alone selling prices (treated as a new contract) or are the remaining goods or services not distinct from those already transferred (modification of existing contract)?
How is the revenue going to be adjusted? Do you need to do a prospective allocation or a cumulative catch-up?
How do these changes affect the corresponding asset and liability balances that are going to require adjustment as part of this change?
Furthermore, as contracts begin, you will likely incur a variety of expenses that are separate from the direct cost related to the specific subscription product or service. Sales commissions are a great example–how are you going to allocate every single one of those expenses over multiple periods and how do contract modifications impact contract cost assets?
How do contract modifications and incremental expenses complicate revenue recognition?
There are five steps in ASC 606 subscription revenue recognition, and because subscription contract modifications and incremental expenses occur at various times, performance obligations and revenue recognition rules must reflect these changes accordingly. Whenever there is a qualified contract modification, there is a need to assess the goods and services and their selling price - which could pose new and unique recognition challenges. Typical revenue recognition leading up to the change may result in a cumulative catch-up which could increase or decrease the revenue recognized.
There may be innumerable contract modifications and incremental expenses that will need to be accounted for in more complex revenue contracts. As requirements change as a result of contract modifications or there is a need to capitalize certain costs related to a contract, a basic accounting system, ERP, or a custom tool may be a natural start, but abiding by mandatory revenue recognition principles can get convoluted fast–even with in-house revenue recognition experts.
How do you streamline revenue recognition processes related to these changes?
Once you pass a certain level of subscription growth and contract complexity, a more robust revenue recognition tool will be necessary to help automate compliance with standards like ASC-606 and ASC 340-40. Make sure the solution can accommodate complex contract modification rules and expense allocations efficiently to reduce the risk of revenue reporting errors and reduce audit costs.
With modern accounting standards, contract modifications and incremental expenses can pose challenging risks for many subscription organizations. As a business, your finance team should not have to waste countless hours in manual, error-prone accounting tasks to comply with revenue recognition standards. If you want to upsell and cross-sell, for example, you should be able to without the difficulties of navigating ASC 606 and subscription revenue recognition principles in general.
The key to revenue recognition is automation, and without automation in complex revenue recognition situations, your business suffers in terms of financials, resources, and more. Recurly’s revenue recognition solution responds to the greater need for accounting automation. This feature streamlines complex revenue reporting processes associated with subscription contracts and automates compliance with ASC 606 and IFRS 15 guidelines. In addition to streamlined processes, the biggest benefits of a revenue recognition tool include:
Improved revenue visibility, reporting accuracy, and predictability
Accelerated financial close
Reduced compliance risk
Support for evolving business requirements and scalability
With a reliable revenue recognition tool, contract modifications and incremental expenses can be easily handled in the background so you can focus on growing your business faster, smarter, and stronger.