The Importance of Proper Revenue Recognition
In this post I am going to discuss the importance of proper revenue recognition. The incorrect treatment of the revenue associated with multi-month subscription sales leads to an improper understanding of a business’s true profitability and leads to skewed margins on the profit and loss statement (P&L). I will walk you through a basic example showing how the P&L is affected by multi-month subscription sales.
I’ve had the privilege of helping many subscription box entrepreneurs with their accounting. One recurring theme I see is the improper handling of multi-month subscription revenue. This can be dangerous, as often the owner views their business as being much more profitable than it actually is. This is generally more pronounced in the Christmas season when multi-month gift subscription purchases peak. When multi-month subscriptions are sold, the business receives a large amount of cash up front for the obligation of delivering boxes in the future. More often than not, I see all of this cash being recognized as revenue on the P&L immediately when the cash is received. By not properly deferring the revenue associated with these multi-month subscription sales, both revenue and the gross margin are skewed. This is unfortunate because once proper P&Ls are prepared owners are often surprised when their profitability and margins are not as good as they originally thought. Let’s look at a basic example to see how by not deferring the revenue from multi-month subscription sales, your P&L will be misleading and give you an improper understanding of how your business is performing. Let’s assume a business sells, collects the cash for, and ships 100 boxes per month between January through November at a price of $30 per box:
This is straightforward so far, as the company has sold, collected the cash, and shipped the boxes all in the same month. All cash collected is earned, since the boxes for which the cash was collected are shipped in the same month the cash is collected. Now let’s assume in December the company has a campaign to sell 6-month subscriptions and is very successful, selling 100 6-month gift subscriptions. For ease of calculations and illustration, I will account for these 100 6-month subscriptions by showing the total number of boxes sold (100 subscriptions x 6 monthly boxes each subscription, for a total of 600 additional boxes sold in addition to the 100 recurring monthly boxes). The first box from these 100 6-month gift subscriptions sold will be shipped in January of the following year. So in December a total of 700 boxes are sold (100 normal recurring boxes plus the 600 from the 100 6-month subscriptions), which is $21,000 in cash collected (for simplicity I’m assuming there is no price discount for the 6-month subscriptions). Only the 100 normal, recurring single-month subscriptions are shipped in December. How much revenue should we recognize?
At this point I will introduce the concept cash-basis accounting and accrual-basis accounting. Under the cash basis, which is very common for many subscription box businesses, revenue is recognized as cash is collected. The business would recognize the full $21,000 collected as revenue in December:
Notice however that only the 100 usual monthly recurring boxes were actually shipped in December. The first monthly box for the 100 6-month gift subscriptions sold in December will ship in January. So none of the cash collected from those 100 gift subscriptions was truly earned in December. Under the accrual method the cash collected from these multi-month sales will begin to be recognized as revenue in January 2020 when the first of the six monthly boxes is shipped, and would continue to be recognized monthly until the sixth and final box is shipped in June 2020. If we recognize revenue for only the 100 recurring subscription boxes that were sold, paid for, and shipped in December (and defer the revenue from the multi-month subscriptions until the period they are shipped), we get the following for the month of December:
Notice the $18,000 difference in revenue for the month of December. Here are two partial annual P&Ls to help illustrate the impact on gross profit and gross margin percentage. Let’s use a cost of goods sold of $18 per box sold (which would give a 40% gross margin at the individual box level). For fiscal year 2019, our revenue and gross margin look like this when recognizing revenue as cash is collected:
However, under the accrual method, our gross profit and gross margin look like this:
Note the key difference is the number of boxes sold versus shipped. Under the accrual basis, the recognition of revenue is triggered only when the underlying box is actually shipped. In 2019 only 100 boxes each month were paid for and shipped each month, and 600 boxes (100 6-month subscriptions) were sold but not yet shipped. The cash-basis P&L artificially inflates revenue and the gross margin. In this example, revenue is overstated by $18,000 for the year (which is the cash collected for the 100 6-month subscriptions not yet shipped) and the gross margin is overstated by 20 percentage points. The effects of recognizing all of the cash collected from the multi-month subscriptions sold in December will continue to manifest itself throughout the life of the multi-month subscriptions.
Let’s look now at January 2020 when the first month of the 100 6-month subscriptions will be sent. Remember we are assuming a 40% margin for each box, so at a price of $30 our cost of goods sold per box is $18. In January, under the cash basis of accounting, we would recognize as revenue only the $3,000 collected from the 100 recurring monthly boxes that are sold, paid for, and shipped in January. In addition to the recurring 100 monthly subscriptions, we will also ship the first month of the 100 6-month gift subscriptions that were sold in December:
How can our gross margin be negative? It’s not. If we would have properly deferred the revenue from the 100 6-month subscriptions sold in December and recognize the first months revenue in January when the first boxes are shipped, we get the following:
In this case we would recognize revenue for the 200 boxes shipped in January (100 normal recurring monthly boxes plus the first month’s shipment of the 100 6-month gift subscriptions sold). Revenue and cost of goods sold lines up, and gross margin is the expected 40%.
You can see how gross profit and gross margin can erratic by using a cash-basis accounting method and not properly deferring revenue until the appropriate period. Cash-basis P&Ls cannot give the owner any useful information about profitability and margins.
The above example makes an assumption that cost of goods sold are being recorded in the proper period. This is a second challenge subscription box owner's face. Oftentimes inventory is purchased a month or two or more prior to the month it ships. In this case it is necessary to ensure that inventory is expensed only in the month it is actually shipped. The importance of this will be addressed in a second article.
If you would like to discuss how I can assist you in properly tracking revenue please reach out to me via the contact form on the main page of boxedupbookkeeping.com or email me at firstname.lastname@example.org.