It seems as if there’s a new SaaS business that pops up each day. If you’re getting one started or have been operating one for a while, it can still be difficult to figure out how to account for your books, especially items such as COGS or even your sales.
SaaS companies, in particular, build their businesses around billing clients for something the customer hasn’t even utilized yet, which can get tricky in the accounting world. Let’s discuss the guidelines on revenue recognition as a SaaS business.
What is Revenue Recognition?
Revenue Recognition is one of those extensive terms in accounting that can become more complicated than it seems. To put it simply, it’s how your business records its revenue.
Once you get paid, you mark that as revenue, right? Not exactly.
It’s important to realize that there is a difference between receiving cash to your bank account versus revenue. Not all payments received can be deemed as revenue, at least not immediately.
There are two ways to recognize revenue; cash-basis accounting versus accrual accounting.
- Revenue is recorded as cash hits your account, and expenses are recorded as the money leaves your account
- This does not take into account any money owed to you (receivables) or owed to your vendors (payables)
- It’s very simple to maintain your books and even file your taxes, as it just follows the transactions in and out of your bank account
- Revenue is recorded when it’s earned, not when the cash is received
- Takes into account your payables and receivables, making it optimal for forecasting
- Businesses that earn more than $25 million per year are required to use accrual accounting
The Importance of Accounting Standards
Accounting standards are in place to make it more streamlined for businesses to report their revenue and for stakeholders to understand their reporting. They make it more unified across different industries and companies.
The Financial Accounting Standards Board has set guidelines in place such as GAAP (Generally accepted accounting principles) to ensure that businesses understand how to report their revenue. One of these practices is ASC 606 which offers clarity in how businesses should report their revenue.
ASC 606 offers a 5-step model to understand how to record revenue.
- Identify the contract – What are the expectations for both the customer and your business on what is to be provided by each party?
- Identify the performance obligation – What are the deliverables in the contract?
- Determine the price – What is the price of the performance obligations/deliverables?
- Allocate the transaction price – How is the pricing divided among the course of the contract?
- Recognize Revenue – Revenue is split over the term of the contract as your customer benefits from the product or service
Revenue Recognition in the World of SaaS
There are 5 requirements to be able to recognize your billings as revenue in the SaaS world, but one of the main points is that it takes a month for the buyer to be considered in control of the product and assume the risk and reward. This really comes into play when it comes time to close the books each month.
Can a business report the revenue from a sale on the 25th of the month for an annual subscription?
Probably not. Because the customer hasn’t been using the product for more than a month by the 31st so the risk and reward hasn’t been transferred nor has the control of the product. There are also several situations in which the customer might require a refund or additional services.
Let’s look at some possible scenarios.
Specifics of SaaS Revenue Recognition
Consider a situation where you are selling an annual subscription for $6,000. We know we can’t just report $6,000 once we collect it, as that’s not in line with accrual accounting and ASC 606.
We also have to consider separate service lines for this company. What if they offer more than just an annual subscription as most companies do? How do we account for set up fees, customization support, or consultations? If these aren’t included in that same $6,000 fee, we’ll need to account for them over a different time period or possibly in a different way.
- If it’s just a flat $6,000 fee for the year, we would recognize the $500 in the first month and then each month going forward, another $500 is recognized until the end of the year.
- If you add on another service such as consultations for the first 6 months for $6,000, the duration is different now. You’d still recognize $500 for each month of the software subscription, but now you add on reporting another $1,000 for the consulting income and that would end after 6 months instead of the 12 months for the annual subscription.
- If the company offers a $2,000 one-time set up fee, the way you record this would depend on whether or not you include this as a part of the same service line as the annual subscription. If it’s included with each package you sell and is a mandatory add-on, you would still need to divide this among the duration of the contract, i.e. $166.67 per each month for 12 months.
Key Metrics to Track
Now that you have a better understanding of revenue recognition and how to properly record your SaaS revenue, the question becomes how should you track your revenue to stay on target with your goals?
Bookings vs Billings
This an important distinction to make and track. Bookings are customer commitments to pay while billings are the actual invoiced amount. Bookings will help you forecast your incoming revenue in future periods. Billings can tell you what you’re more likely to make in the shorter term.
It’s important to see how your bookings align with your billings to make sure your cash flow is staying steady. You want to actually be billing your client for the amounts you are forecasting from bookings; otherwise, you’re not making as much as you are predicting and possibly budgeted for.
Annual Recurring Revenue (ARR)
ARR is the amount of money you are forecasting from annual subscriptions, which is important to know if you’re trying to gauge your expected revenue in the longer term.
Monthly Recurring Revenue (MRR)
MRR is broken down by month and can be divided into these 3 divisions:
- New MRR is the amount of new subscription revenue in that month
- Expansion MRR is the amount of revenue gained from any upsells from an existing subscription
- Contraction MRR is revenue lost from these monthly subscriptions for various reasons. It could be from full cancellations, to discounts given, or even downsizing a subscription.
Partner with us
This is a confusing topic and there are many situations that can arise that make it even more complex. No need to worry about it too much because that’s how Founder’s CPA can help. We make SaaS revenue recognition as well as other accounting situations easy to understand!