A critical part of every organization, your ability to accurately recognize revenue is what keeps your SaaS business healthy. Not to be minimized or put on the back burner, but the insights provided by SaaS revenue recognition are key to knowing your financial performance. For example, if you want to improve your profitability, you’ll need to increase your revenue – and to do this you need an accurate view of your performance. Although the SaaS business model provides countless benefits; when, how much, and how to recognize revenue can quickly become complex.
Let’s take a look at what SaaS revenue recognition is, its unique characteristics, the five steps of revenue recognition, and how to simplify SaaS revenue recognition for your organization.
What is SaaS Revenue Recognition?
According to Investopedia, revenue recognition is a generally accepted accounting principle (GAAP) that identifies the specific conditions in which revenue is recognized and determines how to account for it. Simply stated, SaaS revenue recognition is the process of converting cash from bookings into revenue. However, complexities can and do arise in determining when you can convert cash into revenue.
To illustrate, we’ll take a look at a couple of basic examples.
Example 1: You sold an annual contract to a new customer for $24,000, receiving full payment immediately. Can you recognize the $24,000?
Example 2: A current customer extended their annual contract of $24,000, paying $2,000 per month. Can the $24,000 be recognized immediately?
The answer to the question in both of these scenarios is no. In example 1, you have the $24,000 in your account, however you haven’t yet earned the total amount. You are, however, able to recognize $2,000 of revenue each month until the contract expires. Example 2 is less convoluted since you’re receiving $2,000 per month from the customer and have delivered the agreed to services, meaning you have earned the ability to recognize $2,000 each month.
Basically, SaaS revenue can only be recognized when the business earns it, which leads us to our next topic – the unique characteristics of SaaS revenue recognition.
Unique Characteristics of SaaS Revenue Recognition
Saying that SaaS revenue recognition is unlike other models would be an understatement. Most SaaS businesses offer different subscription plans and pricing models such as , usage-based, hybrid billing, dynamic billing, along with countless combinations.
Also, SaaS businesses encounter additional complexities in recognizing revenue when one or more of the following occur:
- Subscription cancellations prior to the contractual end date
- Upgrades from basic plans to top-tier plans
- Downgrades from top-tier plans to basic plans
- Services provided
- Inability to collect money owed
For each of these situations, revenue recognition needs to be adjusted appropriately. We’ll explore each of the scenarios to demonstrate how the event affects revenue recognition.
Subscription cancellations prior to the contractual end date
How you determine revenue recognition adjustments depends on the contract between you and the customer. If the contract states that refunds will be provided for cancellations prior to the end of the contract, you’ll recognize revenue up to and including the last month prior to the cancellation date. The remaining funds, if paid up front, are credited back to the customer. When the contract stipulates that early cancellations are not refunded, you recognize the deferred balance amount as revenue the first month of the cancellation. And in this case, no credit is issued to the customer.
Upgrades from basic plans to top-tier plans
We’ll use an example to illustrate how plan upgrades affect SaaS revenue recognition. Let’s assume that mid-way through the contract year, say June 15th, your client requests a plan upgrade that would take their annual payment from $12,000 to $24,000. Revenue recognition for June would be $1,500 ($500 for the first 15 days of June and $1,000 for the last 15 days of June). Revenue recognition for July – December will be $2,000 a month.
Downgrades from top-tier plans to basic plans
We’ll now reverse the above scenario for plan downgrades. Using the same criteria, revenue recognition for June would be $1,500 ($1,000 for the first 15 days of June and $500 for the last 15 days of June). Revenue recognition for July – December will be $1,000 a month.
When you can recognize revenue from services varies on the services. We’ll take a look at two common types of services you may be providing.
- Implementation services: There are two scenarios that determine when you can recognize revenue from implementation services. If the customer chooses to outsource the service to you it’s considered separate from the software purchase, and will be recorded as revenue at the time that the service is completed. On the other hand if the service isn’t distinct from the software revenue then will be recognized over time.
- Professional services: Similar to implementation services, you need to determine if the training, custom development or other professional services are separate from the software subscription. For example, are the services sold on a stand-alone basis or can the customer purchase the services from a third party. If either of these conditions are true, you’ll recognize revenue when the service is complete. When professional services are provided over time, you’ll most likely recognize revenue at predetermined milestones.
Inability to collect money owed
According to the GAAP, when payment is uncollectable, you need to report it as a bad debt. If a portion of the invoice is recognized, the uncollectable money owed is written off as a bad debt.
While this isn’t an exhaustive list, it gives you an idea of the complexities SaaS businesses encounter in recognizing revenue. In an effort to simplify and standardize revenue recognition, the Financial Accounting Standard’s Board (FASB) and the International Accounting Standards Board (IASB) jointly developed the Accounting Standards Codification 606 (ASC 606), which provides a five step model for revenue recognition.
Five Steps of Revenue Recognition
Essentially, ASC 606 provides businesses with a framework on when they can recognize revenue and how much revenue can be recognized. The process consists of the following steps:
- Step 1: Identify the contract with the customer. This outlines the criteria when establishing a contract with a customer to provide goods or services.
- Step 2: Identify the performance obligations in the contract. This step describes the performance or deliverable obligations.
- Step 3: Determine the transaction price. Outlines the factors that need to be taken into consideration when establishing the transaction price.
- Step 4: Allocate the transaction price. This outlines guidelines for allocating the transaction price across the contract’s distinct performance obligations. It’s what the customer agrees to pay for the goods and services.
- Step 5: Recognize revenue when or as the entity satisfies a performance obligation. Revenue can be recognized when the business meets each performance obligation.
As you can see, SaaS revenue recognition can be complicated. However, there are steps you can take to simplify the process.
Simplifying SaaS Revenue Recognition
You want and need to recognize revenue as soon as possible, while adhering to ASC 606 guidelines. With BillingPlatform you can automatically assign financial transactions and execute revenue recognition as events take place. Our rules-based revenue scheduling provides the flexibility to automatically allocate transactions to specific GL accounts, eliminating error prone manual effort. BillingPlatform provides an all-in-one revenue recognition solution that supports the entire quote-to-cash process. ASC606 and IFRS 15 compliant, our software allows you to configure every aspect of revenue recognition – without IT intervention or custom coding. Find out more by talking with our experts.