Analyst Perspectives

Zuora, a subscription commerce and billing software company, recently acquired Leeyo, a company that provides software that automates the revenue recognition and forecasting processes. The terms were not disclosed. The acquisition is relevant to subscription-based businesses because of changes to accounting standards about to go into effect that will have a significant impact on how they account for their revenue. Leeyo and Zuora already have been deployed together with multiple ERP systems. The combined company plans to tighten integration between the two going forward.

As I’ve noted, in 2014 the U.S.-based Financial Accounting Standards Board (FASB, which manages US-GAAP) and the Brussels-based International Accounting Standards Board (IASB, which manages IFRS) issued ASC  606 and IFRS 15, respectively, which express the agencies’ harmonized approach to governing revenue recognition for contracts. More on the impact of these standards below.

Zuora has grown rapidly over the past few years for several reasons. As my colleague Mark Smith has noted, its software helps companies adapt their marketing, sales, customer engagement, operations, finance and even IT to subscription-based processes. The expansion of the subscription economy, which my colleague Richard Snow has been involved with for more than 20 years, is another factor that has contributed to the company’s growth. Our benchmark research on recurring revenue reveals that finance and accounting departments using a third-party dedicated billing system are more often satisfied than others with their invoicing: 85 percent said they are satisfied or somewhat satisfied, compared to 73 percent that utilize a custom-built in-house system, 69 percent that use ERP systems and just half (50%) that use spreadsheets.

Companies that have even modestly complex subscription billing arrangements typically find that dedicated software simplifies their billing process, reduces their accounting workloads and can substantially reduce billing errors. Companies that have adopted or are considering adopting subscription billing software will have an especially complex task accounting for revenues under the new standards for several reasons. One is that it’s common for these contracts to include multiple elements (such as different subscription types, services, products or hardware) that usually require different accounting treatments depending on the contract language and circumstances. A second reason is that customers of these businesses often add or reduce services during the subscription period. The mechanics of accounting for these changes can be complicated and time-consuming if handled manually. A third reason is that the new standards represent a fundamental, conceptual change in how companies account for revenues and their associated expenses related to contracts. Rather than being based on company-centric events (such as shipping an item or billing for services performed), revenue is recognized when the customer is satisfied. This introduces complexity in the timing of when companies can recognize revenue related to the contract.

Accounting for contract-related selling expense also can be problematic, as I’ve noted. The cost of sales commissions associated with obtaining the contract can be capitalized and then amortized over the life of the contract, while incentive payments to sales managers associated with obtaining the contract cannot. Here, too, when the contract is modified by adding and subtracting services, the mechanics of accounting for sales compensation can become difficult.

Leeyo’s cloud-based RevPro software deals with these complexities, handling revenue recognition and forecasting. Its rules-based engine automates revenue recognition processes and provides accurate revenue treatments consistently. It integrates with any ERP system or can operate on a stand-alone basis. Because it is rules-based, the software quickly adapts to changes to revenue recognition standards and guidance. It handles the revenue recognition process and associated deferred revenue management, including fair-value calculations and grouping of contract types. This is especially useful when contracts are modified during a subscription period. The software also deals with the cost of sales, sales commissions, rebates and accruals, as well as other expense items related to the revenue recognition process. In addition, it supports both ASC 606 and IFRS 15 for companies that must report results under both accounting regimes. This is important, because although the intention was to create identical standards for US-GAAP and IFRS, over time it’s possible that the two will diverge because of differing interpretations. RevPro also provides revenue forecasting, which is essential to the planning, budgeting and review processes, as I have written.

The merger of Leeyo and Zuora is timely since most companies in North America are just now coming to grips with making changes to comply with the new standards. To be charitable, there’s been some confusion about the new standards because of repeated delays in establishing them over the past decade. Perhaps for this reason, our informal research finds that a very large percentage of affected companies have only started the process of implementing changes to their systems, perhaps operating on the mistaken belief that there would be a further delay in implementation. Those with a December fiscal year-end will be scurrying to have their systems in place by the end of this year, making it likely that many will use spreadsheets as a stopgap to deal with the accounting. This is likely to cause problems.

I recommend that companies with subscription revenue business models manage their billing process using dedicated billing software and that, as soon as possible, those companies implement dedicated revenue recognition software to manage this process. In my opinion (thankfully, I’m not an auditor), using spreadsheets to handle accounting for subscription revenue constitutes a material weakness. ASC 606 constitutes a shift from a heavily rules-based approach to revenue recognition accounting to one that is more principles-based. The latter allows for greater leeway in accounting treatments as long as the methods are consistent. Readily auditable business rules built into revenue recognition accounting software provide a high-level control that ensures that such treatments are consistent. Spreadsheets lack these controls, and our Spreadsheets in Today’s Enterprise benchmark research confirms that they are error-prone: 35 percent of participants said they are common in the most important spreadsheets they use in their job.

I recommend that subscription-based companies that aren’t using a dedicated subscription billing system evaluate the Zuora and Leeyo combination. Subscription-based companies that use spreadsheets to manage revenue recognition are likely to find their accounting staffs stretched to the limit in keeping track of ongoing transaction details. Despite the time their accountants spend double and triple checking their spreadsheets, they will likely find errors cropping up frequently and will spend more audit hours ensuring that they have followed procedures correctly.

Regards,

Robert Kugel

Senior Vice President Research

Follow me on Twitter @rdkugelVR