7 THINGSTO THINK ABOUT FOR

ASC 606(If you're a subscription company)

You may have heard by now that new accounting guidelines must be implemented soon. Public companies need to adopt it for annual reporting beginning after December 15, 2017 and Private companies get an additional year. This new, converged standard known as ASC 606/IFRS 15 was jointly issued by The Financial Accounting Standards Board and the International Accounting Standards Board.

So before the 2018 fiscal year reporting period sneaks up on you, ask yourself: is your subscription-based company ready to adopt the new revenue recognition standards? Companies that follow specific industry-based GAAP, such as communications, media, IOT, healthcare, education, cloud software and service providers in particular should take note.

Whether your subscription-based business is looking forward to the new standards or having a hard time preparing for the transition, companies will have to remain vigilant in advance of ASC 606’s rollout. While the standards are centered around revenue recognition, there may be a number of impacts on your company’s data management, accounting, pricing, and billing practices.

This guide is designed to help you assess your business and identify potential roadblocks before they become business problems.

INTRODUCTION2

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THERE ARE 7 THINGS THAT EVERY SUBSCRIPTION-BASED BUSINESS SHOULD CONSIDER:

I. Distinct performance obligationsII. Discounts over a period of time III. Usage-based pricingIV. Evergreen subscriptionsV. Bundling multiple products togetherVI. Ramp pricingVII. Mid-term price change or scope change

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UNDERSTAND YOUR DISTINCTPERFORMANCE OBLIGATIONSI

Customer CompanyContract

Performance obligation 1: SoftwarePerformance obligation 2: Training

First — what does it mean to have a distinct performance obligation? Under ASC 606, a performance obligation is “a promise to transfer a good or service” by an Entity to its Customer. For example, signing up for Netflix (netflix.com) means that Netflix has a “performance

obligation” to provide you unlimited access to its library of streaming content. On the other hand, signing up for Netflix’s dvd service (dvd.netflix.com) means that Netflix might now have a separate “performance obligation” to let you rent from their dvd collection.

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Many companies will need to reassess their business to figure out what their performance obligations are according to ASC 606 guidance — they can’t assume that every line item listed in an order form is a distinct performance obligation. Should Netflix consider their streaming service and dvd service as distinct performance obligations? It depends. If your company sells software and implementation hours to set up that software, are those two separate performance obligations? It depends.

Take a moment to consider your own “contract” with your customer base. “Performance-based revenue recognition” is now the basis of the new revenue standards, so outlining what a performance obligation is will be more important than ever.

Subscription companies usually offer time-based discounts. You often see “Free trial for 7 days” or “50% off the first 3 months.”

For example, customer service platform Zendesk offers time-based discounting in the form of a “Unicorn Feed” or one free year of service for startups under $1M in funding. While the platform is usually $117 for 12 months, Zendesk offers a 100% discount for the first year.

This seems like a pretty attractive deal from the customer’s side of things, but it complicates things when it comes to reporting the actual revenue, especially when the guidelines for reporting revenue has changed under ASC 606. For a subscription that offers a discount like Zendesk, the customer will be billed less through the duration of the discount, in this case 12 months. However, just because the customer is billed less doesn't always mean less revenue will be recognized in that year.

DISCOUNTING ISA MATTER OF TIMEII

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If your company wants to offer a similar discount structure as what we described above, then according to the new revenue rules, you may be able to recognize revenue in the first year despite receiving $0 from customers. Because “performance-based revenue recognition” is based on the goods/service you provide to a customer, how much you bill a customer is separate from how much revenue you can recognize.

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USAGE-BASED PRICINGIS VARIABLEIII

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Charging a customer based on usage is a pretty common thing for subscription businesses. Industries ranging from rent-a-car companies to airlines use this model - we often see customers charging per seat, per mile, per GB, per number of transactions, and more.

Under current accounting practices, usage-based pricing implies that you bill a customer and recognize revenue based on how much of a

product is used. For example, let's say a company sells data services and charges customers with tiered pricing based on GB of data consumed. That means customers get a price concession based on the total volume of data they consume in the calendar year. "Use more and pay less per GB" - this is a good incentive for customers to increase usage. Customer will be billed in arrears at the end of the year.

GB used

Quarter 1

5 X $100

$500

GB used

Quarter 2

15 X $90

$1,350

GB used

Quarter 3

55 X $80

$4,400

GB used

Quarter 4

85 X $80

$6,800

CUSTOMER, USAGE PER QUARTER

PRICE1-10 GB

$100/GB/quarter10-20 GB

$90/GB/quarter50+ GB

$80/GB/quarter

As you can see, the customer benefits from price concession as usage volume increases. This customer will receive a bill for $6,800 at the end of the year. But ASC 606 will require this company to calculate the effective revenue price in each Quarter by estimating the annual usage. As a result, the company will have to make a price adjustment by estimating the variable component

of the transaction price in each Quarter before recognizing the revenue. For instance, the company will need to make the downward adjustment in Quarter 1 by an amount of -$100 as a variable consideration. Things are changing with ASC 606 and IFRS 15. Under new guidance, you are expected to take the variable consideration of a contract into account.

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EVERGREEN MEANSHAZY CONTRACTSIV

When it comes to subscription businesses, you have at opposite ends A) businesses such as enterprise software companies and cell phone service providers that require customers to sign a contract, and B) business such as Hulu, GoPro, or Intercom that provide an evergreen subscription without a termed contract. If you fall in the latter category and offer evergreen subscriptions, you might need to consider how

you’re going to handle revenue recognition with the new revenue standards.

The new ASC 606 standards mandate that companies recognize revenue against contracts, but since evergreen subscriptions do not force customers into a contract, how will such subscription services comply?

Under the new guidelines, companies that offer evergreen subscriptions will need to find a way of recognizing revenue despite not having a defined contract. That means under ASC 606, every company has to decide for themselves, what is the 'term' that they want to use in order to accurately determine a revenue contract for their evergreen subscriptions. Is it aligned with the billing period? Is it an estimated amount of time that reflects the average customer lifetime length? For companies offering evergreen contracts, these questions need to be answered prior to the implementation of ASC 606.

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BUNDLING AFFECTS SELLINGPRICE & ALLOCATIONV

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If you’re selling bundles — the grouping of different services into one offer — today, then you surely know about multi-element arrangements for revenue recognition. With ASC 606, the terms VSOE and multi-element arrangements are getting a facelift.

When it comes to bundling, the keywords you should pay attention to are "standalone selling price" and "allocation." Let’s take an example. Say your company prices a healthcare management software for $800 per year and training for $200 per year. If a sales rep decides to bundle

those two services together and sell the healthcare management software at a discount for $500 while throwing training in for free, does that mean the training has no value in terms of generating revenue? (Hint: no.) The new standard will require companies to both estimate the standalone selling price of each individual offering and allocate the total transaction price of the contract across each offering based on the relative standalone selling price.

STAND ALONESELLING PRICE $800 per year $200 per year

$500 per year Free

$400 per year $100per year

HOW YOUSOLD

HOW YOURECOGNIZE SoftwareTraining

Here’s what happens in that situation.

The Standalone Selling Price (SSP) for the healthcare management software is $800 while the SSP for training is $200.

When you bundle Software and Training together, 80% of the bundle is allocated for software while 20% is allocated for training.

Because the customer paid a total of $500 for that contract, the total Transaction Price is $500.

Since the Transaction Price of this particular deal was $500, then 80% of that ($400) will be allocated to revenue for software while 20% of that ($100) will be allocated to revenue for training.

THERE IS PLENTY OF GUIDANCE ON HOW TO CALCULATE ALLOCATIONS FOR BUNDLED DEALS, BUT IMPLEMENTING SUCH ADVICE FOR THOUSANDS OF CONTRACTS IS A CHALLENGE WITHOUT AN AUTOMATED SOLUTION

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A NEW WRINKLEIN RAMP PRICINGVI

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A “ramp” contract implies that a customer pays more over time. Ramping a subscription over three years might mean that the customer pays less in the first year, more in the second, and even more in the third. This translates into increased revenue from the customer. Ramp pricing is common in the Software-as-a-Service (SaaS) industry for enterprise contracts. Not only does it offer the benefits of a lower entry price point but also a higher exit price, which could be used as leverage in negotiations during the renewal sales cycle.

Subscription companies using this pricing plan will soon have to comply with the new standard, whereby revenue is recognized in a straight line across all three years instead of being recognized based on one year’s charge to the customer. For example, a company might offer a 3 year ramp contract for their enterprise marketing software and ask customers to pay $10K in the first year, $20K in the second year, and $30K in the third year. In this case, the customer is billed $10K more year over year but the company recognizes $20K every year of the contract.

With performance-based revenue recognition, the amount of revenue you're recognizing for a ramp deal is the same year-over-year— since you're providing the same service — even though you are billing the customer more each year.

BILLING-BASED REVENUERECOGNITION

1 YEAR 2 YEAR 2 YEAR0

10000

20000

30000

40000

Billing Revenue

PERFORMANCE-BASEDREVENUE RECOGNITION

1 YEAR 2 YEAR 2 YEAR0

10000

20000

30000

40000

Billing Revenue

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MID-TERM PRICE ORSCOPE CHANGESVII

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Every change to a subscription impacts revenue. Customers upgrade their plans, add more users, pause their subscription during summer vacation, and so forth. On average, there are 4 mid-term changes for any subscription every year.

With ASC 606, mid-term changes requires more vigilance than ever before. Every change to a contract requires businesses to reassess revenue recognition. Your company will need to reassess your contract with the customer to determine if

there is an impact to the existing revenue contract, the existing performance obligations, the overall transaction price, and the timing of the revenue recognition.With any change to the service, be it adding, subtracting, or changing the type of service your business provides; you will need to assess and evaluate what the accounting treatment should be as it depends on the nature of the change.

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Doing all this manually is hard. Revenue recognition is difficult enough on its own, but under the ASC 606, you will need to rethink and revise your current accounting practices. We encourage you to get a head start and begin assessing whether your business will be impacted.