Most traditional businesses and companies, revenues come from selling products and services. These revenues came when a company sold a product or rendered a service to a client.
Then, accounting standards dictated that companies must record these revenues when the risks and rewards get transferred. Usually, this was the same time as the company made the sale.
However, new business models have introduced many complications to the recognition of revenues for companies. Companies make revenues from several sources nowadays.
Similarly, these revenues may also cover several obligations the supplier will deliver later. Therefore, the same accounting rules don’t apply to recognizing revenues for these companies.
Accounting standards have changed to streamline the process of recognizing revenues. The latest revenue accounting standard is IFRS 15, which treats them as contracts.
There are several types of revenues that this standard covers. One of these includes subscription revenues from a subscription-based business model.
Before understanding its accounting, it is crucial to know a subscription model.
What are Subscription Revenues?
As mentioned, most traditional companies offer their customers products and services at a specific time. However, newer companies have started providing these products and services.
Through this, they have prolonged the period for which they make revenues. The product and services have remained the same while the revenues have increased.
One business model that companies use for this purpose is the subscription-based business model. With this model, companies provide products and services over a specific period.
These products or services do not change hands. In other words, the customers do not get control of it. However, they can use them if they pay a regular fee, usually monthly or annually.
Through the subscription business model, companies charge customers at regular intervals. In essence, the customers pay for the right or privilege to use the company’s products or services.
Therefore, the company gets a perpetual revenue stream from a single product or service. The revenues earned from the subscription model are known as subscription revenues.
Overall, the subscription-based business model has existed for a long time. However, it has become more popular recently due to the surge in e-commerce businesses.
Companies have significantly increased their revenues due to this model. Despite that, it has also resulted in complications in accounting for subscription revenues.
How do Subscription Revenues work?
The best way to explain how subscription revenues work is through an example. One of the most prominent brands that get these revenues is Netflix.
Netflix is a company that offers online content in exchange for a subscription or membership fee. There are several packages that the company offers. However, they are all essentially the same.
Netflix has an online platform through which it provides access to content. The company charges its customers a subscription fee in exchange, which is monthly.
This fee provides users with access to the company’s online platform and content. For that period, the customer can access Netflix and view online content. Once the period for the subscription expires, they lose access to the platform.
The revenues that Netflix generates from its subscribers are known as subscription revenue. This revenue does not involve similar sources as traditional businesses.
Instead, it comes at regular intervals in perpetuity. The company receives these revenues as long as the customer renews their subscription. Once they cancel their membership, the revenues stop.
Subscription revenues allow companies to make money from the same products and services. In Netflix’s case, the product is its platform and the content hosted on it.
The company focuses on improving its quality to continue receiving subscription revenues. The company also has various packages that allow it to increase its revenues even further.
What is the Accounting for Subscription Revenue?
The accounting for subscription revenues poses a challenge to new companies. Traditionally, companies recorded revenues when the risks and rewards of the underlying products got transferred.
However, in the case of subscriptions, the product never gets transferred. Even when it includes perishable items, the revenues relate to the service rather than the underlying products.
However, the requirement for risks and rewards has become obsolete due to the new accounting standards. Instead, IFRS 15 handles subscription revenues and treats them as contracts.
Furthermore, it identifies five steps for recognizing revenues from these contracts. Companies must follow these steps to account for revenues. These include the following.
- Identify a contract.
- Identify the performance obligations within the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligation identified.
- Recognize revenues as the performance obligation is satisfied.
With the above criteria, companies can recognize subscription revenues. Usually, the first step of identifying a contract is straightforward.
However, the performance obligations and transaction price may be challenging to determine. Furthermore, allocating those obligations to the transaction price will depend on the process.
Traditionally, companies recognized revenues when they satisfied performance obligations. In the case of subscriptions, it may occur as a continuous process. However, companies usually receive the amount from the customers in advance.
Therefore, accounting standards don’t allow them to recognize it as revenues at the time. Instead, they must account for it as deferred revenues. As they satisfy the performance obligations, they must transfer those amounts to revenues.
What are the journal entries for Subscription Revenue?
The journal entries for subscription revenue are straightforward. However, companies must satisfy all of the above steps to recognize it.
Companies usually receive an upfront payment from their customers as a subscription fee. However, accounting standards require the recognition of revenues when earned.
Companies can’t record the received amount as revenues due to this requirement.
Nonetheless, companies must record the receipt. For the debit side, the accounts may include cash or bank based on the type of transaction.
For the credit side, it will consist of the deferred revenues account. This account helps record revenues companies have received but haven’t earned. Therefore, the journal entries for subscription revenues will be as follows.
Once the contract term comes to an end, the revenue becomes earned for the company. Therefore, it must use a subsequent journal entry to transfer the deferred revenues to sales. The journal entries for this transfer will be as below.
A company, ABC Co., has an online cloud-based application for which it charges customers a subscription fee. The company offers the product for $15/month.
The number of customers for the company is stable at 10,000 each month. At the start of each month, ABC Co. charges users’ accounts for the subscription fee.
The company receives cash through the bank, but the revenue only becomes earned at the end of the month.
Once ABC Co. receives subscription fees, it records them as deferred revenues. This amount remains in the account until the end of the month as accounting standards require this treatment. Nonetheless, the accounting entries for the transaction are below.
|Bank ($15/month x 10,000 customers)||$150,000|
At the end of the month, the subscription revenue becomes earned. Therefore, ABC Co. transfers the amount recognized as deferred revenues to the sales account. The journal entries for the transaction are below.
In the past, the process for recognizing revenues was straightforward. However, new business models required a change in accounting standards.
One such model was the subscription business model, which gives rise to subscription revenues. These revenues come from the membership or subscription fee that customers pay at regular intervals.
The accounting for subscription revenues falls under the scope of IFRS 15.