SaaS Revenue recognition is imperative for tracking the financial health of your business. It is worth mentioning here that revenue provides a glimpse of the financial performance of the company. If you want to strengthen the bottom line of a company, you need to increase revenue.
To increase revenue significantly, you need to have an accurate picture of revenue. Even though SaaS business has a competitive edge over the traditional business models in many ways, recognizing revenue accurately here is a bit complex and cumbersome.
For this reason, we have decided to nail the accounting process employed in the SaaS business for revenue recognition.
As an owner of a SaaS business, if you recognize the cash earned from the bookings inaccurately, you’ll end up with a gloomy picture of the company’s income.
What is SaaS Revenue Recognition?
Revenue recognition is the generally accepted accounting principle (GAAP) that specified rules for revenue recognition. Furthermore, it aids the accountants in recording revenue correctly.
However, complexities often arise while determining revenue while you are converting the cash receivable from service subscriptions into revenue.
To keep that in perspective, let’s take some real-life examples:
1. Your customer bought a subscription plan of $36,000 and paid you immediately. Can you recognize that $36,000 as revenue?
2. A current customer upgraded their annual contract of $36,000 and start paying you $3,000 per month. Can you recognize the $36,000 as revenue immediately?
The answer to both of these scenarios is a big no. In the first scenario, even though you have $24,000 in your account, the service hasn’t been rendered by the customer for a full year. You can only recognize $3,000 per month as revenue till the expiration of the contract.
Example 2 is relatively less complex because you are receiving $3,000 per month from the customer and have agreed to deliver the service. Thus, you are free to recognize $3,000 as revenue per month.
Simple speaking, revenue recognition is an accrual accounting principle that defines how and when you should record business sales as revenue.
Your business revenue doesn’t necessarily need to be equivalent to an amount in the pipeline or in your bank account. When a customer pays you for a service that hasn’t y been rendered yet, this amount becomes a liability for the company and is known as unearned revenue.
Upon providing the customer agreed service, you could recognize that payment as revenue. SaaS revenue recognition is paramount to the success of every company irrespective of its size and customer base. Particularly for those companies who are contractually obliged to report their financials to their shareholders.
For a traditional brick and mortar shop, when you receive a payment for goods, you could recognize that payment as revenue immediately. On the other side of the spectrum, revenue recognition in a SaaS that is a subscription-based business demands a different accounting practice.
A business pays the upfront cost for a service that continues over a couple of months or years. However, businesses can only recognize the payment as revenue if the contract continues till the expiration date.
Key Guidelines for SaaS Revenue Recognition
If you SaaS Company starts a contract with a customer to provide a specific service, you need to comply with the ASC-606. These principles were framed by the Financial Accounting Standards Board (FASB) and International Financial Reporting Standards (IFRS).
The purpose of these principles is to meticulously adhere to the generally accepted accounting principles.
These SaaS revenue recognition principles frame the process for revenue recognition during the transfer of service using the following steps:
Step 1: Identify Contract with the Customer
This specifies the criteria that need to be met when initiating a contract with the customer to provide a specific service.
Step 2: Identify the key obligations in the contract terms
It describes all the performance obligations when the contract is being framed. If the service doesn’t meet the customer’s satisfaction, the company should have to compensate the customer.
Step 3: Evaluate the transaction price.
It specifies the factors that need to be taken into account during the evaluation of the price.
Step 4: Allocate transaction price
This defines how the transaction price is allocated across all the performance obligations agreed upon in the contract.
Step 5: Recognize revenue when the performance obligations are met
Revenue can only be recognized at a point in time when the customer enjoys the service and the customer express satisfaction with the service.
This rule describes that revenue earned from a single customer is distributed evenly in accordance with the signed contract between the SaaS Company and customer.
If the service delivered to the customer remains the same throughout the full year, there will not be any modification in recognition of revenue.
For instance, if a customer enjoys the same service for a 12-month contract, your SaaS business can recognize 1/12th of the contract price as revenue each month as your customer is also receiving 1/12th of the service.
However, if the nature of service varies significantly throughout the contract, your SaaS business could not expect steady revenue throughout the contract. Eventually, that inconsistency also reflects in the proportion of revenue your business recognize each month.
To evaluate revenue your business has earned in the specific period, all you need to do is to look at the revenue recognized from each customer each month. All this data will be readily available in your company’s revenue schedule.
With this schedule, you can make adjustments in your allocations in case of any upgrade or downgrade in the company’s contract. As a result, you can minimize the chances of over or underestimation of the future revenue.
For instance, let’s say the customer no longer wants to pursue the contract, you can update the schedule and stop recognizing the revenue-generating from that contract each month.
In some cases, you might have to refund the portion of the initial transaction that was recorded in the financial statement as deferred revenue but hasn’t been recognized yet.
On the flip side, if a customer switches to a more advanced subscription plan, update the revenue schedule with a higher price each month. Therefore, you’ll end up recognizing a higher revenue each month.
Key Metrics in SaaS Revenue Recognition
Before we delve deeper into details, here are some core concepts of SaaS revenue recognition:
Deferred revenue is the amount you have billed your customer but cannot recognize that amount as revenue because the agreed service hasn’t yet been provided. From the accounting perspective, this revenue is referred to as unearned revenue.
Deferred revenue is perceived as a liability because if you fail to deliver the agreed service, your business will be liable to refund that money to the customer.
Unbilled revenue is revenue that a company has recognized but hasn’t yet billed the customer due to the billing schedule and billing milestones described in a contract. Unbilled revenue is recorded as a receivable asset till the company bill the customer.
Monthly Recurring Revenue (MRR) and Annual Recurring Revenue (ARR)
The most fascinating feature of SaaS business is its ability to generate recurring revenue. From ARR, a SaaS Company can gauge the revenue from an annual subscription. Whereas Monthly Recurring Revenue (MRR) is a revenue converted into a monthly figure.
Following are the types of MRR:
New MRR: the revenue company generates when a customer purchases a subscription plan.
Expansion MRR: The additional revenue generated from an existing customer.
Contraction MRR: A noticeable decline in the SaaS Company revenue due to cancellation of subscription plan by the customer or due to downgrading from top-tier plan to basic plan. Or due to the discount availed by the customers.
Having a firm understanding of these metrics is an integral part of a SaaS finance team responsibility.
Booking is a forward-looking metric and is an indication of a signed contract with the prospective customer for a particular timeframe. Simply speaking, bookings describe your customers’ commitment to pay you money for the service they are consuming.
In the case of a contract comprising of many years, bookings that have at least one year of committed revenue falls under the category of Annual Contract Value (ACV) bookings.
While ACV talks about annual contracts, Total Contract Values (TCV) are calculated by taking into account the complete duration of the contract. Furthermore, there are non-recurring bookings wherein customers are supposed to pay only one time fees like setup fees, discounts, and training fees.
Booking is one of the key determinants of company revenue growth. It helps companies to track the growth of sales. Aside from sales, booking helps the finance team and CFOs in managing inflowing and outflowing cash.
Moreover, it helps companies to record bookings as the committed revenue while maintaining the books of a company without recording them as revenue. Thus, it eliminates all kinds of inaccuracies during the calculation of ARR and MRR.
Billings are the invoices that a customer is liable to pay for a certain time period, for instance, a couple of months or a year.
If a SaaS Company has a high booking but significantly lower billing, it will certainly experience a future cash flow problem. To ensure a healthy cash flow, a SaaS company should have to rethink ways to promote upfront payment from the customers and increase billings.
This goal can be easily achieved by offering customers substantial discounts on annual payments.
is the money that a company earned when a customer consumes a service. A company could only recognize revenue for a month upon the delivery of service to a customer for the full month. This is in accordance with the GAAP rules that states that revenue could only be recognized when it is earned.
Mere relying on billing and booking to gauge the financial performance of a company simply means you are tracking inflated numbers. This approach could be devastating for the financial health of your company.
To cope with this problem, the more accurate way is to only keep an eye on the recognized revenue that indicates an actual revenue that a company earns by providing service.
So far we have discussed the key SaaS metrics that a finance team should be aware of. From now on, we’ll be exploring how to calculate MRR, billings, and bookings.
Accrual Accounting Principles
In accrual accounting, revenues and expenses are only recorded when they are earned or incurred. Accrual accounting best suits the SaaS business because it relies on the subscription-based model. If a SaaS Company recognized the accrual revenue correctly, only then a company could track the MRR appropriately.
This method is better than cash base accounting where businesses record revenue when cash actually comes in and liabilities are paid. Despite its complex nature, accrual accounting principles are widely used by growing SaaS companies
A SaaS company that has more than $25 million as gross revenue should adopt accrual accounting principles to comply with IRS (Internal Revenue Service).
|Provides a more accurate representation of a company’s net profit at a given time||Requires intense bookkeeping and is a bit complex.|
|Helps with better forecasting of future revenue and expenses||Income is only recorded when a company actually earns it. So the company won’t pay taxes on the money it hasn’t earned.|
Why Should a Company Follow Accounting Standards?
The rule and guidelines of financial accounting and reporting are developed by the financial standards. Revenue Recognition is amongst the principles of Generally Accepted Accounting Principles that is endorsed by the Financial Accounting Standards Board (FASB).
Many countries follow its alternative under the name International Financial Reporting Standards (IFRS) which is enacted by the International Accounting Standards Board (IASB).
The Growth of Accounting Standard Codification (ASC) 606
According to the statement issued by the Financial Accounting Standard Board, the revenue recognition requirement of IFRS lacks sufficient details and accounting standards of the US. For this reason, GAAP was deemed inappropriate in some areas.
To resolve these issues, FASB and IFRS coalesced to lay down the foundation of a new revenue recognition system called ASC 606 that only deals with revenue earned from the customer.
ASC 606 creates a robust framework for revenue recognition for many industries. This eliminates unnecessary confusion around the SaaS that often arises due to inconsistent practices and inappropriate accounting practices.
Key Challenges in SaaS Revenue Recognition
For a SaaS company that offers an annual subscription plan, revenue recognition is pretty much straightforward and counterintuitive. But complexity arises due to a slight change in the subscription plan:
· Cancellation of a subscription in the middle
· Upgradation from the monthly to annual plan in the middle of the year.
· Downgrade from an enterprise plan ($25000/month) to a basic plan ($7500/month).
It becomes more complex with an introduction of new features that comes with SaaS:
· Setup fees
· Support fees
· Consultation fees
· Customization cost
· Consumption-driven cost
Depending on the performance obligations and ability of the company to deal with them, SaaS Companies have many revenue recognition methods to choose from. Some well-known revenue recognition methods are the cost recovery method and the completed contract method.
In complex revenue scenarios, revenue needs to be recognized separately. Let’s explore each of the scenarios individually.
SaaS Companies Revenue Recognition Scenarios
Suppose that a SaaS Company provides an e-ticketing service to its customers. The company offers three subscription plans to its users; basic plan, pro plan, and enterprise plan of $3000, $6000, and $12000. The company also provides the flexibility to its customers to add more users when required.
Revenue Recognition for an Annual Plan
Supposes a customer purchased an annual plan of $6000 per month starting from January. In this scenario, recognizing revenue will be fairly simple.
The company billed the customer with an invoice of $6000 at the start of January. But as we have discussed earlier, only $500 will be recognized as revenue in January. Therein the real irony lies in how to record the revenue that is collected but hasn’t yet been recognized.
In this scenario, the accountant records the remaining $5500 as deferred revenue.
Upon the completion of each month, another $500 will be recognized for the services delivered to the customers. This process continues till the end of December when the SaaS Company fully met the customer’s obligations.
· The invoice created in January will be for $6000.
· Revenue recognized in January: $500
· Deferred revenue in January: $5500
· Revenue recognized on 31st December: $6000
· Deferred revenue on December: $0
Revenue Recognition for Upgrade in Subscription Plan
The customer decides to update from pro to an enterprise plan i.e. from $6000 to $12000 on the 15th of May. An accountant prepares an MRR plan for the month of May that shows the MRR for May would be $1000.
From the revenue recognition standpoint that solely depends on the billing and the service customer consumed, it is how the sequence of events with regards to the revenue recognized in April would look like:
· Invoice raised in January: $6000
· Revenue recognized till 30th of April: $2000
· Revenue recognized till 15th of May: $250 (for 15 days of consumption of service)
· Total revenue recognized from 1st January to 15th May: $2250
· Credit note raised = $3750
· Net prorated invoice raised for $7500
· Net revenue recognized in May: $750 ($250 for the first 15 days of May and $500 for the remaining month of May)
· Deferred revenue at the end of May: $7000 (prorated invoice of $12000 was raised from the 15th May to 31st December)
· Revenue recognized in the remaining months (from June to December): $1000/month.
Revenue Recognition for Quantity-Based Upgrade
If a customer wants 10 additional users in an existing pro plan on 1st May, at the cost of $10 per agent in the remaining months, then it falls under the category of quantity-based upgrade.
In this scenario, a new invoice will be raised for an additional 10 agents.
· Invoice raised in January for $6000.
· Revenue recognized from January to April: $2000.
· Quantity-based upgrade from 100 to 110 agents on 1st of May charged at $10 per user
· Prorated invoice created in May for $4000.
· Revenue recognized in May and the remaining months: $600($500 + ($10*10 additional agents))
· Deferred revenue in May: $4200
· Deferred revenue in June: $3600
Revenue Recognition for Downgrade in Subscription Plan
If a customer decides to downgrade from an existing pro plan of $6000 to a basic plan of $3000 on a 15th May. Here is how the revenue is recognized in this scenario.
Revenue recognized from 1st May to 15th of May is $250. After downgrading the subscription plan, a credit note of $3750 will be raised and revenue recognized from 15th May to 30th May will be $125.
· Invoice created in January for $6000.
· Revenue recognized from January to April: $2000.
· Revenue recognized from 1st May to 15th May: $250
· A credit note will be raised for $3750
· A new prorated invoice will be generated for $1875
· Net revenue earned in May: $375
· Revenue recognized in the remaining months from (June to December): $250/month
· Deferred revenue in May: $1750
· Deferred revenue in June: $1500
Revenue Recognition for Cancellation with Refunds
The customer subscribes to the annual contract of SaaS Company that costs $6000 in the month of January. However, the customer decides to cancel the contract in May.
The SaaS Company could experience two possible scenarios based on how the company would like to implement its contractual rights.
In case of cancellation followed by a refund claim, the customer cancels its subscription at the start of May and claims a refund. The SaaS Company recognized revenue till the end of April.
To substantiate the cancellation of the subscription plan, the company raised a credit note of $4000.
Revenue Recognition for Cancellation with Refunds
In case of cancellations with refunds, the customer cancels its subscription at the start of May. However, they are not entitled to receive partial or full refunds.
In this scenario, the balance deferred amount will be treated as revenue and no credit note will be created.
Developing a great product that addresses your targeted customer needs is imperative for the success of SaaS business. However, recognizing revenue correctly is equally important to retain the commercial viability of SaaS products. If you fail in this step, your ability to make future financial gets affected.