SaaS Revenue Recognition: Do’s and Don’ts

Have you struggled to figure out how to handle your startup’s SaaS revenue recognition properly?

Revenue recognition can seem confusing and counter-intuitive, especially if it’s your first SaaS business.

While some smaller businesses meeting specific criteria may elect to use cash-based accounting, accrual-based accounting becomes necessary once things get more complex. This requirement applies even more once you’re looking to raise outside capital.

Accrual accounting can make revenue recognition extra tricky, especially with a SaaS business.

What is SaaS Revenue Recognition? Why is it Important?

The basic principle of SaaS revenue recognition (along with many other aspects of accrual accounting) is recognizing revenue in line with service delivery. The revenue recognized corresponds with the monetary value of the services provided.

In short, the timing of your sales should align with what you’re delivering to your customers.

To properly understand how revenue recognition works for SaaS businesses, you need to understand the difference between bookings, billings, and revenue.

Bookings are the value of the sale when you sign with a customer.
Billings refers to the amount of cash you get from your customer.
Revenue is what’s recognized when you provide service to your customer.

Accurate revenue recognition is vital for several reasons, primarily because revenue affects profitability, affecting what your business pays in taxes.

But, proper revenue recognition also lets you see your startup’s monthly recurring revenue (MRR). MRR and other profitability metrics are essential for steering your SaaS business.

The Do’s of SaaS Revenue Recognition

There are a few basic things to pay attention to for proper SaaS revenue recognition. Following these tips helps make sure you’ve got the basics covered.

Do Comply with ASC 606

ASC 606 is a standard for handling revenue recognition published jointly by the IASB (International Accounting Standards Board) and FASB (Federal Accounting Standards Board). It ensures that revenue reporting is dealt with consistently across many different businesses.

In ASC 606, there are five steps for properly dealing with revenue recognition.

Identify the contract with a customer. Outline the criteria established in your contract for supplying services to the customer.
Identify the performance obligations in the contract.
According to the contract, what does the customer receive from you, the supplier? Do they simply get access to your tools each month? Or, by using your service, are they expecting a specific outcome?
Determine the transaction price.
How much does the customer pay for the goods or services? How much does your business expect to receive for completing the service?
Allocate the transaction price.
How is the transaction price split across the different performance obligations? How much does your company receive for each portion of the service delivered? This allocation may be as simple as splitting an annual contract into 12 equal payments.
Recognize revenue as the entity satisfies its performance obligation.
When does your company (the service provider) meet the different performance obligations outlined in your contract? Measuring the level of contract fulfillment is crucial for determining how much revenue can be recognized. In some cases, it may be as simple as recognizing 1/12 the value of an annual contract each month.

Do Use a Deferred Revenue Account

In most cases, all money that comes into the business will be sent directly to a deferred revenue account on the balance sheet. When you’re ready to recognize the revenue, you’ll move it to the sales account in the P&L.

This process helps keep your books straight and lets you see exactly how much revenue you have.

Do Learn How Distribution of Revenue and Deferred Revenue Look Across Channels

Breaking down how your startup makes money and where it comes from is critical decision-making information. This information can help you see which products are most profitable and which need closer examination.

The Don’ts of SaaS Revenue Recognition

Along with the “dos” there are a few things to steer clear of when dealing with your SaaS business’s revenue recognition.

Don’t Recognize Revenue until Services for the Revenue Have Been Provided

This alignment is the key behind proper revenue recognition and the purpose for rules like ASC 606.

Recognizing more revenue than you should inflates your revenue (and profit) figure and makes it look like you have more money than you actually do. The contract with the customer hasn’t been completely fulfilled, but you may have no more revenue to cover the costs of keeping the tools running.

This mismatch can affect your cash flow and overall profitability.