As of December 1, 2018, new guidance was issued by the Financial Accounting Standards Board (FASB) regarding how to recognize subscription revenue in the financial statements. This is significant as it impacts not only what companies report but also when they report it!
Prior to this update, different accounting principles were used across various industries and for different timeframes. Now there is one consistent approach that must be followed at all times.
This article will go into detail about why this matter is so important and which types of businesses are likely to feel the impact the most. It will also talk about some potential pitfalls related to these changes and ways to avoid them.
We will begin with an introduction before moving onto the bulleted points.
The timing of when you begin offering a service-based product or program is important. You cannot recognize revenue for an online yoga studio that offers classes exclusively through a subscription until it has both offered some level of class access at no cost as well as unlimited access, right?
Similarly, you can’t recognize revenue for a fitness app that only costs money to use after users have paid either for the smartphone app or for the premium membership.
By having these two initial conditions, your income statement will now show additional revenues from monthly subscriptions.
In fact, this is how most apps and websites make their profits! Most apps offer a free version with limited features but up to a certain number of uses per month before users are asked to pay for more resources.
This way, they earn revenue while still providing value without requiring payment. It’s how Netflix and YouTube manage to remain popular.
However, not all companies can afford to do this yet. It takes time to build up a loyal following, and even longer to convince people to pay for new services. This is why many big brands rely heavily on advertising instead — the advertisements promote their products so people will buy them.
Recent guidance from the IRS requires that you recognize revenue in two different ways depending on how your business operates. The old rules said that you had to include both direct product sales as well as service-related products or services under one category called “services”, which then required you to allocate part of the services cost to each product sold.
The new standard is much more practical and straightforward. Starting this year, you only have to treat service- related revenues as product revenues if they satisfy either of the following conditions:
They represent a separate line item on an invoiced statement with no additional mention of services other than what is mentioned on the invoice. For example, if someone orders a software package but also asks for some consulting services, it would be considered two distinct lines on the receipt with a separate amount for consulting.
or there is specific evidence such as a contract stating that the individual receiving the benefit will pay for them separately, like through monthly dues at a membership organization.
When you offer a monthly or yearly subscription, you will sometimes get reports that they have canceled their membership. This happens for several reasons: if they cannot afford to continue paying your site, then you lose them as a customer; they may find your services annoying and want to stop using them; or they may be dissatisfied with your service and are trying to terminate it as quickly as possible.
Whatever the reason, this is totally okay! You should not feel bad about this because it is part of your business model.
It is important to recognize these cancellations correctly in order to keep proper records. For example, if someone cancelled their annual membership but still paid for a month-long trial period, record just that as a cancellation of an extended warranty plan rather than a full year’s worth.
Likewise, if someone only “lapsed” (remained inactive) on your site, don’t count that as a lost sale since you didn’t receive any revenue from them.
Recent developments in accounting for subscription services revolve around how to treat recurring revenue. This is significant because most large companies rely heavily on subscriptions as their main source of income.
Subscriptions can be monthly or yearly, and customers typically pay up front with each renewal. This means that even though the company may not receive the money at once, it receives it over time- which is important since tax laws require you to recognize this type of revenue soon!
Mostly, accountants choose one of two strategies when recognizing such revenues. The first is called the proportionality method, where the cost of service is divided into an approximation of how many months/years of service there will be.
This is dependent on both the length of the subscription and what level of service the client gets during that time frame. For example, if a person purchases a monthly magazine membership, then they would allocate enough time to cover the whole year for recognition of the sub-service.
The second option is the pre-payment method, where no integration takes place until later. With this approach, the costs are recorded immediately before the sale, but only taxed as regular revenue instead of subscription revenue.
There is nothing wrong with subscribing to your favorite brands or companies, but you must be clear about how subscription revenue is reported in the books of your business. Most online sellers include a plan that offers monthly or yearly subscriptions as part of their product offering, which makes it easy for customers to add them to their cart.
But what happens when they decide not to purchase those services? Many vendors don’t recognize this cancellation as a loss because it isn’t considered “sales activity." This can result in lower revenues being reported, even if the customer has spent money outside of your company's control.
As a seller, make sure you're correctly accounting for these cancellations by including an extra note in your financial statements explaining why the deduction was made and how much was lost due to the cancellation. You should also research whether or not your industry has specific rules and guidelines for reporting cancellations so you know what to do if yours don't exist.
Recent changes to IRS guidance require that you recognize this as deductible business-related expenses, rather than expensed product returns.
Under old rules, if your business offered a monthly subscription service for music or video, it was considered an extended sale of the item – so revenue was recognized at the time of purchase, not when the customer cancelled their plan.
This made more sense before most people had access to free streaming services like Spotify and Netflix, but now it’s impossible to ignore!
Since streaming is usually less expensive per month than buying a single album, many consumers choose to stream instead of buy. This means no extra tax bill for the same thing!
For example, say you sell movie and TV show subscriptions with a monthly cost of $10 each plus a small one-time setup fee. You also offer a 30-day trial period, which is common in the media industry.
After three months, customers have paid enough money to deserve a refund, so they can either keep the service or cancel altogether.
If they opt to stay, however, they will still pay the monthly fees until they decide to stop, making the remaining underpayment income.
Recent changes to how Amazon accounts for revenue disclosure require us to be even more careful in how we recognize subscription income.
In May of 2018, Amazon made significant revisions to their standard policy regarding refunds. These new policies state that customers can ask for a full refund within 30 days of purchase if they are dissatisfied with your service.
This change was made due to reports of some companies taking advantage of this feature by offering poor services or no services at all. By allowing people to cancel without interruption, these companies earn higher revenues than they would otherwise.
By including this clause, Amazon is making it clear that they will not tolerate such practices. This update has also been referred to as the “Netflix effect” because many large corporations use it to promote shareholder value.
These types of reforms have become increasingly common as business owners realize the importance of honest marketing strategies.
Recent changes to how Amazon accounts for subscription revenue are confusing and frustrating for sellers. This article will clear up any confusion and tell you what you need to know about this revision to its accounting procedures.
