Revenue recognition for service and subscription businesses

Revenue recognition sounds like a technical accounting topic best left to the year-end file. In practice it is one of the few areas where a policy choice made without much thought will distort your margin analysis, your forecast, your commission scheme, and the multiple a buyer eventually puts on the business. It is worth the hour it takes to get right.

The principle under both IFRS and the UK and US equivalents is straightforward: recognise revenue as you transfer control of what you promised, in the amount you expect to be entitled to. Everything difficult flows from identifying what exactly was promised, and when it is delivered.

Where service businesses go wrong

Fixed-fee projects are the common failure. Revenue is recognised when the invoice is raised, which follows the payment schedule agreed with the client, which bears no necessary relationship to the work performed. A project billed fifty per cent up front shows a very profitable first month and a loss-making third one. Nothing about the underlying engagement changed.

The fix is to recognise over the delivery period on a defensible measure of progress, usually costs or hours incurred against the total expected, with unbilled work sitting as accrued income and over-billing sitting as deferred income. This requires a reliable estimate to complete, refreshed monthly by the delivery lead rather than assumed by finance. That monthly re-estimate is where the real value is: it surfaces projects running over long before the final invoice does.

Where subscription businesses go wrong

• Annual fees taken up front and recognised on receipt, which flatters the month of renewal and starves every month after it.
• Set-up and implementation fees recognised immediately when they are not a distinct promise and should be spread across the expected customer life.
• Usage and overage revenue recognised on invoice rather than in the period the usage occurred.
• Discounts and free periods recognised as given rather than spread across the whole contract, which distorts the margin on the early months.
• Contracts with a non-trivial termination right treated as full-term when the enforceable period is shorter.

None of these are exotic. All of them are common in businesses that grew fast on a cloud ledger that recognises revenue when an invoice is raised because nobody configured it to do anything else.

Why it matters beyond the statutory accounts

A distorted revenue line distorts everything downstream. Margin by product is wrong because revenue lands in a different month from the cost of delivering it. Sales commission rewards the timing of an invoice rather than the value of a contract. The forecast is built on a revenue history that is really a billing history. And at diligence, a quality of earnings exercise will restate the revenue onto a proper basis, which means the numbers the deal was priced on are not the numbers that survive the process.

Getting it in place

Write a policy of two or three pages covering your actual contract types, with a worked example of each. Configure the ledger to support it, which for most cloud platforms means deferred revenue schedules and a discipline about how contracts are set up rather than a new system. Reconcile deferred and accrued income every month as part of the close. Then apply it to the prior two years, so that the trend the board is looking at is a trend and not a change of policy.