Why the Subscription Economy Must Prepare Now for New Accounting Rules
The latest accounting rule many of your clients must come to grips with is a new standard that covers revenue recognition, which will significantly impact those that participate in the subscription economy.
The subscription economy is all about recurring revenue, where companies offer a product or service—from enterprise software to gourmet meal delivery—for a monthly subscription, sometimes establishing a multiyear agreement with customers.
Starting in 2018 for public companies and 2019 for private companies, ASC 606 and IFRS 15 revenue management guidelines from the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) will require companies to reallocate revenue each time a customer contract changes and defer expense recognition to align with the contract’s delivery.
The scope of these changes will be most significant for companies that offer subscriptions because calculating their revenue and expenses according to the new guidelines will be very complicated for them as their contracts change more often.
Most subscription companies are growing quickly and tend to have lots of customers locked into long-term relationships. But with the upcoming rule change, they must recognize revenue in a new and different ways. This is where it gets complicated.
Let’s say a sales rep from one of these subscription companies signs on a new corporate customer that agrees to pay $300 a month for the next three years. Prior to the new guidelines, the company would pay the sales rep a one-time commission of, say, $1,000 for the booking of that long-term contract and the company would then incur the full $1,000 expense at the time the booking was made.
But under the new guidelines, companies are no longer allowed to do this. Instead, from an accounting perspective, they have to spread that $1,000 commission expense over the lifetime of the contract. As a result, the new guidelines will have a material impact not just on revenue recognition but on the actual profitability of the company.
For companies that need to show profitability, the new guidelines are a potential game-changer. For instance, a subscription company with an upcoming IPO or funding event will need to change the way it structures its contracts and account for its commissions. It may even decide to do shorter-term contracts with customers so it can recognize expenses more quickly, rather than spread them out over a period of several years.
This is not a question of the size of the company. More important is the nature of its business. If a company has an ongoing relationship with customers in which it is delivering products or services over an extended contract period, the company will be impacted by the new accounting rules on revenue recognition. On the other hand, if the company is selling, say, automobiles to individual customers in a single transaction, it is less likely to be affected by the new rules.
The new accounting guidelines are intended to make financial results more transparent and comparable, and to harmonize US standards with international standards. Previously, it was difficult to compare companies that report using international standards to those that report using US standards. Once the new guidelines are implemented, the FASB and the IASB will be in greater alignment.
Though these new accounting guidelines don’t take effect until 2018 and 2019, they will require many companies to rethink the way they do business – and that needs to happen now. The reality is that finance teams in general are so overwhelmed and focused on the short term that they hear the dates 2018 and 2019, and they figure they can worry about it later.
Most don’t understand the scope of the changes necessitated by the new rules. If they did, they would realize that they need to adjust to the changes starting now, especially if they are writing contracts that extend into 2018 and 2019, which many subscription and recurring-revenue companies are already doing.
Here’s an analogy. Say you plan to buy a house in 2018. And then you learn that the rules around credit scoring are going to change in 2018. Clearly you would need to start changing your behavior right now, so when it comes time to buy your house you’ll have a credit score high enough to get the loan you need.
Finance departments need to take action today. I believe the changes coming will rival those brought about by the Sarbanes-Oxley Act, which sought to protect shareholders and the general public from accounting errors and fraudulent corporate practices. Many readers may remember how painful that transition was for many US businesses as they paid astronomical costs to meet the requirements while placing a heavy burden on their finance and internal audit teams.
The truth is that the current accounting systems at many subscription companies simply can’t handle the new revenue-recognition guidelines. The new rules necessitate an extensive review of contracting and accounting policies and processes, and will likely require changes to procedures and systems. Companies with even moderately complex customer contracts are going to find that the new rules will have extensive impacts best dealt with by software designed specifically to handle the new requirements. That means they’d better get on it, pronto.
The subscription economy is here and it is now a vital concern to a growing number of businesses. A recent report by the Economist Intelligence Unit said 80 percent of customers now demand consumption models like subscribing, sharing or leasing—any option other than buying a product outright. Companies that want to thrive will have to offer some form of subscription. And that means they will need to quickly adapt to the new accounting rules.