SaaS Revenue Recognition - everything you need to know explained simply

A SaaS business can be trickier than any other to bear with.

That's because your revenue model is different, and so is the revenue reporting to the IRS.

I am no tax-master myself, and frankly, it took me a good sum of time to grasp the concept wholly.

But I believe I'm ready to help you understand your finances better.

So, let's dive into SaaS revenue recognition standards, and how a software company should set their accounting principles according to their business model.

What is Revenue Recognition in SaaS?

Revenue Recognition is a GAAP (generally accepted accounting principle) that specifies certain conditions in which revenue can be recognized and included in income statements. The same goes for SaaS revenue recognition, it's as simple as it seems, but with SaaS organizations, accepting the literal value may not be the greatest method to account for income.

This actually makes sense, because the payments you have received make your actual revenue, not a written promise between you and the customers.

In other words, the process of turning cash from 'bookings' to 'revenue' is known as revenue recognition.

Bookings... Revenue... Recognition...

I know that there is a lot to take in. 

Let's visualize what that means:

Assume a customer has agreed to pay $2,000 each month for a yearly contract worth $24,000. Is it possible to recognize the $24,000 as revenue right away?

No.

Revenue can only be recognized in a SaaS accounting perspective when the product/service obligations are met.

So, in this simple example, $2,000 in revenue can be recorded each month in exchange for the product/service given until the contract expires.

Simply expressed, revenue recognition occurs when a customer's performance obligation is met.

Why is SaaS Revenue Recognition needed?

Revenue recognition is critical since it is linked to the financial reporting integrity of a company.

The goal of the revenue recognition guidance is to standardize the revenue policies utilized by businesses. External organizations, such as analysts and investors, can compare the income statements of different companies in the same industry because of this standardization.

Because revenue is one of the most essential metrics investors use to evaluate a company's performance, financial statements must be consistent and trustworthy.

What Is Revenue Recognition ASC 606?

The ASC 606 stands for the new revenue recognition guidelines of the accounting standards committee. After the IFRS 15 has been found insufficient for software subscription revenue calculations, the ASC 606 broadened the spectrum of the process.

There are specific guidelines for calculating and reporting revenue for businesses. Here's all you need to know about revenue recognition and ASC 606 compliance for SaaS businesses:

How to Recognize Revenue Under ASC 606

The 5 Step Model for Revenue Recognition in ASC 606 streamlines the production of financial statements. This approach is intended to guide businesses in determining how much and when you should recognize income.

Here are the five steps:

1. Identify the contract:
   This step lays out the requirements for creating a contract with a client to offer goods or services. The contract (written or oral) is mutually agreed upon and describes each party's rights and duties.
2. Identify the performance obligation:
   When the contract is being written up, this describes all of the performance responsibilities or deliverables. If the services or goods are unique, they must be individually accounted for.
3. Determine the transaction price:
   This phase identifies all of the factors to consider when determining the transaction price.
4. Allocate the transaction price:
   This illustrates how the transaction price is distributed among all the contract's performance responsibilities. This also takes into account variables.
5. Recognize revenue:
   Revenue can be recognized in time - or over time as when the customer benefits from your product/service, and is driven by the transfer of control to the customer.

When Should SaaS Revenue be Recorded?

You should record revenue from subscriptions on an accrual basis.

That is, revenue is recorded and recognized when the value is earned rather than when cash or other forms of payment are 'in hand.' In a subscription model, products and services are delivered at different times and over different lengths, making recognition difficult.

To say that SaaS revenue recognition is different from conventional models is an understatement.

Most SaaS companies provide a variety of subscription plans and pricing structures, including usage-based, hybrid billing, dynamic billing, and various other options.

When one or more of the following events occur, SaaS organizations face significant challenges in recognizing revenue:

• Cancellations of subscriptions before the contract's expiry date
• Upgrades from basic to premium plans are available.
• Plans are downgraded from top-tier to basic.
• Inability to recover money owing despite services provided

You must adjust revenue recognition correctly in each of these scenarios. I'll go over each scenario in detail to see how it affects revenue recognition.

Cancellations of subscriptions before the contract's expiry date

The contract between you and the customer determines how you calculate revenue recognition adjustments.

Suppose the contract indicates that cancellations before the end of the term would be refunded. In that case, your company will recognize income up to and including the final month before the cancellation date. If the consumer pays in full upfront, the leftover money is returned back to them.

👉 When a contract specifies that early cancellations are not repaid, the deferred balance amount is recognized as revenue in the month after the cancellation.

In this instance, the customer receives no credit.

Upgrades from basic to premium plans are available.

A common example of this is when a customer upgrades their plan from basic to premium. This change can affect both your costs and revenues.

For example, if the new plan includes additional features, then your cost of providing those features increases. However, the price increase also results in increased sales.

👉 Therefore, the total revenue generated by the product remains unchanged.

Plans are Downgraded from Top-Tier to Basic

This is similar to the previous situation where a customer changes their plan. However, instead of upgrading to a higher tier, they downgrade to a lower tier.

Again, the cost of providing the service decreases, but the price decrease does not result in increased sales.

👉 As a result, the revenue earned on the product remains unchanged. In addition, any remaining balances are refunded to the customer.

Inability to Recover Money Owed Despite Services Provided

This occurs when a customer fails to pay for services rendered.

You may have already billed the customer for the services, but they fail to make payment. The problem arises because you cannot force the customer to pay.

👉 Because of this, you need to recognize the revenue owed to you.

Conclusion

Retaining the financial health of a private company is as difficult as retaining customer contracts.

And considering the changes in the revenue recognition principle for different services to customers, such as SaaS, where monthly revenue is more relevant than daily revenue, painting an accurate picture is more important than ever in accounting practices.

The complex calculation of pricing structures such as usage-based pricing or annual plans for a consulting service period is not an easy task to complete.

I hope I could make the process of understanding subscription revenue recognition easier for you.

P.S. Stay safe.