What is Annual Recurring Revenue?
Annual Recurring Revenue (“ARR”) is a metric that is defined as the value of annual contracts, typically for SaaS or other subscription businesses that offer term subscriptions. ARR is equal to the value of the underlying contracts that are recurring in nature (subject to renewal on at least an annual basis) normalized to an annual basis and is intended to represent how much revenue a company is expecting to receive from recurring customers in the next 12 months.
Generally, the key driver to consider as it relates to evaluating what is included in ARR is the predictability of the recurrence of the revenue, therefore it may be used as a relevant metric for companies/revenue streams outside of subscription or SaaS revenues.
If average customer terms are less than a year, typically Monthly Recurring Revenue (“MRR”) is the appropriate metric to be used instead of ARR.
What is GAAP revenue recognition?
Revenue recognition from contracts with customers under U.S. Generally Accepted Accounting Principles (GAAP) is defined under Accounting Standards Codification (ASC) Topic 606.
Topic 606 requires companies to recognize revenue for accounting purposes based on five steps, whereby the company evaluates the amounts that are expected to be collected and the nature of the transfer of goods/services to the customer. The recognition criteria and considerations in step five requires companies to determine if “over-time” or “point-in-time” revenue recognition is appropriate.
What are the differences?
Annual Recurring Revenue is a non-GAAP metric, as such does not fall under specified rules regarding classification unlike revenue recognition under GAAP. GAAP revenue recognition measures historic information while ARR measures future expected revenues. GAAP revenue recognition appears on the Company’s GAAP financial statements, whereas ARR typically accompanies management reporting, and is often included in the Management Discussion and Analysis (“MD&A”) portion of financial reporting.
ARR is typically used to measure performance and growth of a company that has subscription-based revenues, and is often used by investors as a metric to imply the value of a company by applying industry based ARR multiples, among other valuation techniques. ARR is a non-GAAP metric therefore ARR metrics are not subject to audit, nor can a CPA firm opine on ARR or related metrics as there are no published rules regarding the classification of recurring versus non-recurring revenues.
Revenue recognition under GAAP requires companies to evaluate the nature of revenues, and the pattern of transfer of value to customer. When Topic 606 was adopted (required adoption in 2018 by public companies and 2020 by private companies) some companies specifically in the software/SaaS industries were required to accelerate revenue recognition on certain software license/SaaS revenues from an over-time recognition method to a point-in-time recognition method based on facts and circumstances of how and when the company performs on the contract.
ARR and over-time revenue recognition are often equated, however these classifications are different in nature and in their usage. Additionally, the adoption of Topic 606 has created even more potential differences between ARR used for internal reporting by companies and revenue recognized for GAAP purposes due to possible acceleration of revenue recognition for certain types of licenses. Further, ARR typically includes closed bookings for which executed documents may not be completed and services may not have commenced. Under GAAP this type of contract would not be recognized as revenue until services actually commence, creating timing differences between recognition of contracts as ARR versus revenue under GAAP.
Best practices for tracking and measuring ARR and revenue recognition.
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, and also understand that ARR is not defined under specific rules and regulations.
Based on our experiences the following are best practices as it relates to tracking/measuring ARR and revenue recognition:
- Create a revenue recognition policy which 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’s if subject to audit requirements.
- Create an ARR policy whereby the company’s specific criteria of what constitutes recurring versus non-recurring revenue is identified and agreed upon by the management team and the relevant stakeholders. Ensure this policy is applied consistently. Examples of common policies for ARR include: