How to Recognize Revenue for SaaS Companies
Revenue recognition is a Generally Accepted Accounting Principle (GAAP) that sets the conditions for when revenue can be recognized as income and included on the company’s income statement. The system used by software as a service (SaaS) companies has to be different from traditional businesses because SaaS companies are only allowed to recognize revenue after they have earned it by providing the services their customers prepaid for at the beginning of the service contract.
What is revenue recognition?
Revenue recognition is an accrual accounting method used to match revenue collected by a company with the service or goods delivered to its customers. In traditional businesses, the customer receives the requested goods and/or services and then pays for them. In this model, it is appropriate for the company to record the revenue as income when it receives the money because it has already delivered the goods and/or services paid for by the customer.
What is SaaS Revenue Recognition?
SaaS must have a different accounting system because customers generally prepay for their SaaS goods and services. After receiving payment for the contracted services, the SaaS company delivers them to its customers over the life of the contract. As they deliver the services by fulfilling their contractual obligations, they record the revenue as earned income. This prevents them from declaring income that they have not earned, and that is classified as deferred or unearned revenue. Deferred/unearned revenue is considered a liability until it is earned by the company via the delivery of the contracted services.
Services That Affect SaaS Accounting
SaaS companies deliver a variety of services. The services may include software, online access to services delivered by the company’s platform, and professional services (e.g., software integration, training, repair). These services may be bundled, sold separately, or a combination of both depending on the company and the needs of its customers.
Bundled services are services that are sold as a package to the company’s customers. A packaged service may include the implementation of the software, training on the system, and a person who works as a consultant at the firm once a week for a few hours. These bundled services must be expensed over time based on their value as part of the bundled service package. Thus, by the end of the service contract, all the goods and services will have been paid for, and their assigned package value recognized in the company’s income statement and revenue records.
SaaS companies may also offer standalone services that their customers can purchase without a subscription to their software and that they can purchase in addition to their software subscriptions. For example, a company may want to use the SaaS company’s repair services or its training personnel to help train its people on how to use the software, and get their work done more efficiently.
SaaS services that require some creative accounting include:
|Cancellations||100% refund of unused prepaid subscription if the company offers partial refunds. If there is a no refund policy, then no refund is given if the customer cancels the subscription before the end of the contract.||Any unused prepaid subscriptions become revenue a month after the service is canceled if there is a no refund policy.|
|Service Upgrades||Moving a basic or premium customer up to a higher level and more expensive service plan.||Increased price paid for services, increased sales, overall revenue generated stays the same.|
|Service Downgrades||Moving customers from a premium level plan down to a plan with less value and fewer services.||Service costs decrease in value, decreased sales, part of the original contract’s value refunded to the customer, and overall revenue earned on service is unchanged.|
|Services Provided||The services listed in the original contract that are supposed to be delivered to the customer.||Expensed over the life of the contract.|
|Implementation Services||The cost of setting up the system, integrating the software into the existing software and operating system, and resolving any hardware issues that may affect operation of the system.||Expensed as part of a package deal or recognized as revenue from a standalone service.|
|Professional Services||Professional services supplied by the SaaS company may include on-site training, customization of the system, personalized training, repair services, consulting, and other services that may be requested by the company’s customers.||Expensed as part of a package deal or sold as a standalone service.|
|Defaulting Accounts||When clients do not pay their bills and the SaaS company cannot collect the owed money, they may be forced to write off the bad debt.||An expense that decreases taxable revenue.|
Importance of ASC 606 Revenue Recognition Standards for SaaS Companies
The ASC 606 was released by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) implemented ASC 606 on January 1st, 2018. ASC 606 revenue recognition standards are important because it provides a uniform standard for SaaS companies to record revenue. This uniform standard is invaluable when comparing the revenue generated, profitability, and overall performance of SaaS companies, Although the accounting method isn’t perfect, it does resolve some of the more difficult accounting issues for companies that deliver digital services over time via prepaid subscriptions.
ASC 606 Steps for Revenue Recognition
The ASC 606 has 5 steps for revenue recognition. The steps are:
- Identify the contract that the customer has signed with the SaaS company.
- Identify the performance required by the company to complete the contract.
- Decide the price that will be charged for the contracted service.
- Decide how the price charged will be divided among the services included in the contract.
- Recognize the revenue as it is earned by the company.
SaaS companies use ASC 606 revenue recognition to convert their unearned/deferred revenue into earned revenue. The system does not permit the companies to record prepaid subscriptions as revenue until the company has delivered the contracted services to its customers. It works well in preventing companies from appearing to have earned more revenue than justified by its actual performance. Furthermore, this system treats unearned/deferred revenue like a liability. The revenue is a ‘debt’ the company owes its customers until it has performed the services required to convert the debt into revenue.
While there are still accounting challenges that face SaaS companies, experienced accountants can navigate the terrain and correctly record companies’ assets and liabilities. Furthermore, as the system develops it will become more refined and there will be fewer uncertainties about how to treat non-standard entries and events.
For assistance with SaaS accounting (e.g., accounting, bookkeeping, tax advice), contact the Free Cash Flow (FCF) Agency. FCF has years of experience working with SaaS firms and other types of online service providers, so they can understand your concerns and advise you on how to manage them.