Revenue recognition in SaaS is challenging due to complex subscription models and pricing structures.
Thankfully, ASC 606 provides a step-by-step SaaS revenue recognition model.
Want to know what ASC 606 is all about?
This post will cover everything you need to know about SaaS revenue recognition, including what it is, why it’s essential, and the everyday challenges.
We’ll explore four revenue recognition-related FAQs and walk you through the 5-step ASC 606 framework for recognizing revenue accurately in SaaS.
This Article Contains
- Revenue Recognition SaaS: What is it, and Why is it Important?
- What are the Common Revenue Recognition Challenges for SaaS?
- 5-Step Guide to Revenue Recognition in SaaS According to the ASC 606 Framework
- 4 Revenue Recognition-Related FAQs
Let’s get started!
Revenue Recognition for SaaS: What is it and Why is it Important?
Revenue recognition is a generally accepted accounting principle (GAAP) on how a SaaS company recognizes revenue on its financial statement.
It brings standardization and transparency to financial reporting across industries.
Traditionally, revenue is recognized when:
- The company has provided its products or services to the customer.
- The customer has paid for them.
- Or the payment is reasonably assured.
But why is this important?
Through revenue recognition methodologies, companies can:
- Manage cash flow by identifying the timing of incoming revenue.
- Make better decisions regarding investments, expansion plans, and resource allocation.
- Comply with the ASC 606 accounting standard, reducing the risk of penalties or reputational damage.
- Enhance credibility with investors and shareholders by providing reliable and accurate financial reporting.
However, revenue allocation rules can be complicated depending on your SaaS company’s pricing model.
Here are a few scenarios:
- Subscription service: In a subscription revenue recognition model, the revenue earned is spread equally across the contract term.
- Implementation services: An implementation services based pricing model recognizes revenue based on the number or percentage of tasks completed. The tasks may include data migration, system configuration, user training, etc.
- Bundled services: SaaS companies offer multiple products or services under a single price. For example, a SaaS company may offer a suite of productivity tools, including project management and time tracking software, at $1000 for an annual subscription.
- Prepaid services: In a prepaid pricing model, SaaS companies charge customers upfront for their products and services. In such cases, revenue recognition can occur over the contract term or when the company performs services or delivers products.
Such diversity in pricing models means that a SaaS provider faces several challenges in ensuring the integrity of its financial statement.
Let’s explore some of them!
What are the Common Revenue Recognition Challenges for SaaS?
SaaS companies find it challenging to determine recognize revenue due to:
1. Complex Pricing and Billing Arrangements
SaaS companies use various subscription revenue or recurring revenue models, such as tiered, per-user, feature-based, pay-as-you-go, and so on.
And recognized revenue in the subscription business typically happens over the contract term rather than at the time of sale.
Additionally, some companies may offer discounts or other incentives for committing to a longer-term relationship.
All of these factors make it challenging to recognize revenue from a SaaS accounting perspective.
So, SaaS companies must carefully consider their pricing and billing models and work closely with their accounting teams to ensure compliance with applicable accounting standards.
2. Flexible Contract Terms
SaaS companies offer contracts with different terms and conditions, such as upgrades, downgrades, cancellations, and so on.
These variations could impact monthly recurring revenue because SaaS companies must consider these changes to ensure compliance with the accounting standards.
3. Unique Service Delivery Processes
Determining when a particular service is delivered or performed can be challenging for SaaS companies.
How’s that?
For SaaS companies, service delivery can happen via a fixed product, on an ongoing basis, or based on requests.
And it gets worse!
Sometimes SaaS companies club together different services, where each service is delivered across different contract periods.
In such cases, recognizing revenue for each component requires careful consideration.
With so many aspects at play, it’s no wonder why revenue recognition can quickly turn into a nightmare.
Luckily, ASC 606 was created to standardize how companies in the United States recognize primary sales commissions, improving the comparability and transparency of their financial statements.
Ready to discover the ASC 606 framework?
Let’s dive in!
5-Step Guide to Revenue Recognition in SaaS According to the ASC 606 Framework
The ASC 606 is a revenue recognition framework issued by the Financial Accounting Standards Board (FASB) in May 2014.
Most other countries follow the International Financial Reporting Standards (IFRS 15) regulated by the International Accounting Standards Board (IASB).
It provides a common revenue recognition standard for all contracts with customers across the United States.
These include:
1. Identify the contract with the customer
A contract is a legally binding agreement under which a company provides goods or services to customers in exchange for consideration, such as payment.
SaaS companies must ensure their customer contracts meet the following criteria:
- Both parties have approved and are committed to fulfilling their obligations outlined in the contract.
- The rights of the parties are identifiable.
- The payment terms for the goods or services are clear and measurable.
- The contract has commercial substance, meaning that the expected benefits exceed the cost of entering it.
- The company will probably collect the consideration to which it is entitled.
A legitimate customer contract is essential for recognizing SaaS revenue.
2. Identify the performance obligations in the contract
Under ASC 606, the performance obligations in a SaaS contract are based on the promises made to the customer.
Each performance obligation must be recognized separately in your customer contract.
Common examples of a separate performance obligation are as follows:
- Software license: Authorize the use of its software application for a specific period of time.
- Maintenance and support: Provide maintenance and support services for the software application during the contract term, such as updates, bug fixes, and technical support.
- Security and data privacy: Maintain the security of the customer’s data and comply with applicable data privacy laws.
- Service-level agreements (SLAs): Promise to meet specific performance standards or uptime guarantees, as specified in the SLA.
3. Determine the transaction price
The transaction price is the consideration the company expects to be entitled to in exchange for transferring promised goods or services to the customer.
To determine the transaction price, SaaS companies should consider all the promised considerations in the contract, including fixed and variable amounts that depend on future events. This may include:
- A fixed recurring fee for access to the software application over a specific period of time, such as monthly or annually.
- One-time fee for implementation or professional services, such as configuring the software for the customer’s needs.
- Additional fees for customizing the software to meet specific requirements.
4. Allocate the transaction price to the performance obligations
After identifying the distinct performance obligations and determining the price, the company must allocate the price to each performance obligation.
If the standalone selling price is not observable, the company may need to estimate it using a cost-plus or a residual approach.
The cost-plus approach involves adding a markup, or profit margin, to the cost of producing or providing the product or service.
In contrast, the residual approach evaluates the value of an asset by subtracting all of the expenses associated with the asset, including the expected revenues it will generate.
5. Recognize revenue when the entity satisfies the performance obligation
SaaS revenue should be recognized when obligations to transfer goods or services to customers are satisfied.
For example:
- Cash generated from a license to use the software application should be recognized over the contract term as the customer accesses and uses the software.
- Revenue for maintenance and support services should be recognized as the services are provided.
- According to service-level agreements, proper revenue recognition occurs when the entity meets the performance standards or uptime guarantees specified in the SLA.
If none of these conditions are met, the company should recognize revenue at a point in time when control of the promised goods or services is transferred to the customer.
Disclaimer: The information provided here is simply a rough guide and must not be construed as financial advice. To abide by ASC 606, we recommend consulting with a professional.
Still have some doubts?
Don’t worry! We’ve got you covered!
4 Revenue Recognition-Related FAQs
Here are four frequently asked questions concerning revenue recognition:
1. Cash Accounting and Accrual Accounting: What’s the Difference?
The main difference between the two methods lies in the timing of when the transactions are recorded.
In cash accounting, revenue is earned when cash is received or paid for the goods sold. On the other hand, in accrual accounting, cash received or paid only becomes earned revenue when the promised products or services are delivered or performed.
2. What Is Deferred Revenue?
Deferred revenue or unearned revenue is a liability account that represents income received by a company but has yet to be earned.
Typically, this occurs when a SaaS provider receives payment for goods or services that will be delivered or provided on an ongoing basis or later.
3. What Is Revenue Waterfall?
Revenue waterfall accounting describes revenue flow through a company’s income statement.
It visually represents how revenue is recognized over time and helps understand the components that make up total revenue.
4. What Are the Key Metrics Related to SaaS Revenue Recognition?
Here are some of the vital SaaS revenue recognition-related metrics:
- Monthly Recurring Revenue (MRR): The recurring amount a SaaS business expects to receive monthly from its customers. Typically, recurring monthly revenue is based on the subscription fees charged to customers and excludes one-time fees and discounts.
- Annual Recurring Revenue (ARR): The total recurring revenue a SaaS business expects to receive from its customers over a year. It is calculated by multiplying the MRR by 12.
- Customer Churn Rate: The rate at which customers cancel their subscriptions or do not renew them. A high churn rate can indicate customer satisfaction or retention issues and impact future revenue growth.
- Customer Lifetime Value (CLTV): The total value of a customer over the entire time they are subscribed to the service. It is calculated by multiplying the average revenue per user (ARPU) by the average customer lifespan.
- Average Revenue Per User (ARPU): The average revenue generated per user. It is calculated by dividing the total revenue by the number of users.
Navigate the Complexities of SaaS Revenue Recognition with Ease
SaaS revenue recognition requires careful consideration of subscription and pricing models, delivery of the products and services, and payment terms.
Thankfully, ASC 606 provides a step-by-step guide for companies to recognize revenue.
In this post, we’ve simplified the ASC 606 framework to help you provide investors and other stakeholders with more reliable revenue growth information.
So get set to recognize all that revenue 💰
