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What is SaaS revenue recognition?
Revenue recognition is a principle. It states you have to log revenue as soon as you fulfill a sale. Say someone pays you $5 for an apple. As soon as you give them the apple and receive the money, you have to log your revenue; this is revenue recognition.
The problem is as follows. The principle states you must log revenue as soon as you provide your product. But as a SaaS business, you are delivering a subscription; not a product you hand over once.
This begs the question: “what is SaaS revenue recognition”? How do you recognize revenue when you’re a SaaS business with an intangible product that’s delivered over time?
That’s what we’re going to discuss today. Read on to learn about SaaS revenue recognition, best practices, ways to stay compliant and the helpful ASC 606 model.
What is SaaS revenue recognition?
Revenue recognition is an accepted GAAP accounting principle. It states that your income statement should reflect when and how you receive revenue.
Apply this principle to subscription-based software, and you get SaaS revenue recognition. This is a concept and set of processes SaaS vendors follow in order to stay compliant and precise in their accounts.
To understand why SaaS revenue recognition is special and unique, let’s compare it to traditional revenue recognition.
Traditional revenue recognition
The sale of a product is recognized when the goods are delivered or when services are rendered.
For example, a clothing company sells a T-shirt, which they ship to the customer. The revenue for this transaction would be recognized when the T-shirt is shipped. This is traditional revenue recognition; straightforward and simple.
SaaS revenue recognition
Revenue recognition for SaaS companies is more complicated. This is because SaaS products are typically provided to customers over an extended period rather than all at once.
For example…
- A SaaS business sells a contract worth $30,000
- The client only pays $2,500/month over a year
The business has sold the entire contract upfront and given the client access. But total revenue cannot be recognized until each payment and service are provided. The revenue from this contract will be recognized over 12 months, not all at once.
Why is SaaS revenue recognition important?
SaaS revenue recognition is important for 3 main reasons
1. Compliance. Improper revenue recognition can result in misstatements. Aside from impacting financial reporting, it may lead to legal and regulatory consequences. These implications can often include fines or penalties, as well as cause reputational damage.
2. Accurate data. Let’s say your accounts are inaccurate because of poor revenue recognition. You don’t know how much money you have (or earned last month). There’s no data, which means you’re working blind, with no understanding of your own funds.
3. Financial reporting and planning. If you don’t know what’s going on with your revenue, you can’t report on it. This makes it difficult to create shareholder reports, ask banks for credit, or go public.
Some key areas that are affected by revenue recognition in SaaS include:
- Income statements or profit and loss statements (P&L).
- Reporting receivable, deferred, and unearned revenue on the balance sheet
- Key financial ratios such as gross profit margin, operating margin, and return on investment (ROI)
- Providing insight into the company's performance and financial health for financial statement users like investors, analysts, and lenders.
- Reporting taxable income and paying associated taxes
To stay compliant and effective, SaaS companies must understand revenue recognition principles as set out by the Financial Accounting Standards Board (FASB) and International Financial Reporting Standards (IFRS).
Within the US, the implementation of ASC 606 has changed how all companies, including SaaS, recognize their revenue. The framework provides a 5 step model to determine when and how to recognize revenue per the FASB and IFRS.
ASC 606’s 5 steps to SaaS revenue recognition
The ASC 606 is a 5-step framework. It helps organizations recognize revenue when it has been realized (or earned but not yet realized).
Essentially, revenue should be recognized when a customer has received a product and the company has a right to payment. This standard ensures that companies accurately report their revenue and provide greater transparency.
The 5 steps for revenue recognition for a SaaS company are as follows:
Identify the Contract With a Customer
This is the first step for determining if revenue should be recognized. The contract should state what is being sold and at what point in time the services will be delivered.
Identify Performance Obligations in the Contract
A business must now identify what is being promised to the customer, known as performance obligations. For a SaaS product, this would involve the services being provided, such as access to the software and customer support.
Determine Transaction Price
There are many pricing models SaaS businesses can follow. These include a subscription model, pay-as-you-go, or tiered, among other options. A business must determine theirs when recognizing revenue, as this can vary depending on the contract and customer.
Allocate Transaction Price to Performance Obligations
Once a business has determined how much is being charged, the total should be allocated to performance obligations. For example, a fixed-price 12-month contract would have total revenue divided by 12, with the resulting amount recognized each month.
Note that obligations could include rateable services or usage-based services for SaaS companies.
Recognize Revenue When a Performance Obligation is Satisfied
Finally, a business should recognize revenue as it provides services. This is when both parties have fulfilled their obligations, and a company can consider their revenue realizable.
However, even with this framework, the world of accounting can still be confusing for SaaS companies. With the help of salebricks, businesses can streamline their revenue recognition process and ensure they comply with ASC 606.
6 common problems with SaaS revenue recognition
SaaS businesses often face unique challenges with revenue recognition. These range from multiple pricing models and delivery methods to different entitlements. All of these make revenue allocation difficult.
While the ASC 606 framework helps provide clarity, implementing it can still be challenging. Some of the most common challenges SaaS businesses face include:
Tier Upgrades:
Customers may choose one tier at the beginning of their subscription but then switch to a different tier. This makes it hard to determine the right amount to recognize. In this case, revenue must be allocated to each performance obligation separately on a pro-rated basis.
Subscription Cancellations:
The business must account for the portion of the subscription used or earned when a customer cancels. Once this is calculated, then the revenue can be allocated accordingly.
Renewal Contracts:
Revenue must be allocated over the entire length of a contract, regardless of any period of non-usage.
Changing Payment Frequency:
A customer may change from monthly payment to annual or vice versa. Regardless of how a customer pays, a company must recognize revenue over the life of the contract and when obligations are met.
Services Provided:
If a customer uses a one-off service, such as a bug fix or data migration, that must be accounted for separately. A company can recognize this amount immediately as it is earned.
Uncollectible Revenue:
There may be times when a customer does not pay for the goods and services provided. Businesses must account for this as 'bad debt' and write off the amount.
Salesbricks: SaaS revenue recognition made easy
- Revenue recognition is crucial for all businesses, including SaaS - but it can be difficult to implement correctly. The time spent on manual processes, complex calculations, and paperwork can make it hard for a business to get it right - and mistakes can be costly.
- The 5-step ASC 606 model outlined by the FASB is an essential part of any successful SaaS business but can be challenging to manage without a dedicated resource.
- However, SaaS revenue recognition doesn't have to be hard. Salesbricks can help simplify the process with automated revenue recognition and reporting; businesses can be confident that their financial statements are accurate and compliant.
we do here at Salesbricks.
