Accurate revenue tracking is paramount in understanding the performance and growth prospects of companies, such as SaaS providers, that rely on subscriptions. Investors, management, and finance teams evaluate metrics such as annual recurring revenue (ARR) and GAAP revenue recognition, which, while both related to revenue, serve different purposes and are often confused.
What Is ARR?
Annual recurring revenue is a key financial metric for many subscription-based businesses, serving as a benchmark for tracking growth and providing a high-level view of predictable revenue.
ARR measures the revenue that a business expects to receive from recurring customers in the next 12 months. It is defined as the value of all recurring contracts (subject to renewal on at least an annual basis) normalized to an annual basis.
If average customer terms are less than a year, monthly recurring revenue (MRR) may be a more useful metric.
What Is GAAP Revenue Recognition?
U.S. generally accepted accounting principles (GAAP) define revenue recognition from contracts with customers under Accounting Standards Codification Topic 606 (“ASC 606”).
ASC 606 requires companies to recognize revenue based on a five-step model designed to align revenue recognition with the customer receiving the good or service. This requires a company to evaluate the amounts that are expected to be collected and the nature of the transfer of goods or services to determine the proper amount and timing of revenue recognition.
Step five of the ASC 606 model requires companies to determine whether revenue should be recognized ‘over time’ or at a ‘point in time’. For subscription-based businesses, this consideration often means revenue is recognized over the subscription term, however there are factors that could lead to point-in-time recognition.
ARR vs. Revenue Recognition
There are several key differences between ARR and GAAP revenue recognition. While both metrics are related to revenue, they are not equivalent. Stakeholders need to understand these differences and when the use of each metric is most valuable.
ARR is a forward-looking metric, while GAAP revenue recognition measures historical information. ARR includes only revenues that are recurring in nature, while GAAP revenue recognition will also include any non-recurring items such as implementation fees.
ARR typically includes any closed bookings for which executed documents may not be completed or services may not have commenced. Under GAAP, this type of contract would not be recognized as revenue until services commence.
GAAP revenue recognition appears on the company’s GAAP financial statements. ARR typically accompanies management reporting and is often included in the Management Discussion and Analysis (“MD&A”) portion of financial reporting. Finance and accounting teams are more likely to use GAAP revenue to analyze the company’s performance while investors and company leadership teams use ARR.
Investors often review ARR as a metric to imply the value of a company by applying industry-based ARR multiples, among other valuation techniques. Because ARR is a non-GAAP metric, it is not subject to audit. A CPA firm cannot opine on ARR or related metrics, as there are no published rules regarding the classification of recurring versus nonrecurring revenue.
Best Practices for Tracking and Measuring
For companies in which ARR is a relevant metric, it is imperative that management and the stakeholders understand the differences between ARR and revenue recognition under GAAP. Also, they must understand that ARR is not defined under specific rules and regulations.
Based on our experience, the following are best practices as they relate to tracking and measuring ARR and GAAP revenue recognition:
- Create a GAAP revenue recognition policy in accordance with ASC 606 that is agreed upon by the management team and the relevant stakeholders. Ensure this policy is applied consistently to contracts with customers and reviewed by the company’s CPA if subject to audit requirements.
- Create an ARR policy in which the company’s specific criteria for what constitutes recurring versus nonrecurring revenue are identified and agreed upon by the management team and relevant stakeholders. Ensure this policy is applied consistently. Examples of common policies for ARR include:
| Examples of common policies for ARR |
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| ARR excludes perpetual licenses, implementation and installation charges, and other one-time charges, as well as trial licenses and subscriptions. |
| ARR should exclude non-renewing subscriptions the company is aware of. |
| ARR should include renewable contracts that are less than one year in length; however, the value of the contract utilized should not be annualized for ARR purposes until it is certain the customer will renew. |
| For better usability, disseminating ARR by revenue stream for reporting is preferred (license vs. SaaS vs. support). |
| For better usability, disseminating ARR by customer type (new customers, existing customers, up-sells) and summarizing customer churn information is preferred. |
| ARR includes the annualized value of subscription, term-based, and SaaS licenses, as well as term-based maintenance and support contracts. |
- The treatment of contracts as recurring or non-recurring requires judgment and therefore companies should document relevant policies to ensure the classification is consistently applied.
- Companies should summarize and reconcile ARR and GAAP revenue recognition differences to the board/stakeholders for better usability and understanding of metrics and published financial results.
We hope this article has helped clarify the difference between annual recurring revenue and GAAP revenue recognition and has provided useful information on best practices for each. If you’re a technology company looking for an audit partner, please don’t hesitate to reach out. Our team has experience with a wide range of clients in the technology industry, and we would be happy to chat with you.py to chat with you.
