Tuesday, July 1, 2008

Accounting for Maintenance Subscriptions

Accounting is dry subject matter. Sorry in advance to bore you, but given the current financial climate, I thought it might be timely for you to learn a little more about how we handle the money that you send us.


For most of the history of our company, we did our accounting on a cash basis. [You probably already know this, but if it's been a while since business school, cash basis means that we counted our revenue when we received it, and we counted our expenses when we wrote checks. No sooner, no later, for either one.]

Cash basis accounting is the way that most small businesses function. It is simple, perfectly legal, and easy to implement. Most rep firms we encounter run on a cash basis. But for a company that relies to a large degree on subscription revenue, it is not a very smart way to operate.

Here's why.

As a software company, we annually ask our customers to purchase support and update contracts. Our version of this contract is calledEMA - the RPMS Extended Maintenance Agreement. Near the end of each customer's subscription period, we send them an invoice, and invite them to renew their maintenance subscriptions. Most customers do, and for that, we're always grateful.

But up until about 2003, we looked at the subscription money our customers sent as immediate income, because we operated on that cash basis. That tended to create some awkward circumstances.

For example, when a customer's subscription expired in December 2000, and their 2001 subscription renewal check arrived before year-end, we'd be compelled to count the money as 2000 income. But all the expenses we incurred on behalf of that customer would happen in 2001.

Speaking of 2001 - though I hate to - I hope your business in 2001 was better than ours. Ours pretty much stunk. We'd historically borrowed money during August and September, and that year we had to borrow even more than usual. We managed to turn a profit, but barely. And Brent and I really did not like the feeling of scraping around for short-term funding, when we knew that our business was generally pretty sound.

It seemed to us that if there were some way we could count the subscription income in the month we earned it, as opposed to when we'd received it, our cash reserves would get a whole lot healthier. So in late 2003, we changed our accounting method to an accrual basis, and our business model changed completely.

[Quick accounting refresher: In accrual basis accounting, revenue is recognized only when it is both realized AND earned. 'Realized' means when the cash comes in, but revenue is not 'earned' until products or services are provided. Expenses are recognized in the period in which related revenue is recognized. ]

So what happens nowadays to your EMA subscription money when you send it to us? Well, it goes in the bank, obviously. But as it passes through our accounting system (QuickBooks Pro, if you care) it gets placed in one of twelve different liability accounts, each based on the last month of the subscription. So if your EMA expires in September, your money gets written to liability account number 2409, called "EMA through September".

At the beginning of each month, we make a general journal entry, taking a different percentage of the remaining liability from each month and posting it as EMA Income. For example, at the beginning of November we will take 100% of the remaining liability from the 2411-November account. And we'll take 50% of the balance of the 2412-December account, the rest to come out the next month. And 33% of the 2401-January account, 25% of the 2402-February, etc.

Each subsequent month the percentages shift, such that ALL the remaining EMA is cleared out of the current month's liability account, half from the next month, and so on. It is not really as difficult as I'm afraid I've made it sound. A little spreadsheet cheat-sheet shows the month and the percentages to write as income.

But here's the really useful thing. We have cash when we need it. More importantly, we have money when you need us. We haven't robbed Peter to pay Paul. We don't worry about funding our obligation to provide you with support and programming updates. You've already funded it, and we won't take the difference for ourselves until we've earned it.

A little boring, I know. Not very edgy, this conservative accounting stuff. But since we're asking you for money now and then, we thought you might like to know.