With the fluid nature of an ever-changing marketplace, it is critical for a successful business to monitor their revenue at every stage of the process; this allows them not only to make informed decisions about how much liquid cash they have for spending but also provides them with data to hand over to interested investors.
Fortunately, there are several rules and regulations in place which help businesses to report their revenue appropriately, such as ASC 606. When businesses comply with recognizing revenue to this standard, they are likely to have an accurate portrait of a customer’s expected contract value at all times, even when their subscription changes or becomes more complex.
What is Revenue Recognition?
Revenue recognition can be defined as the process requiring specific conditions in which revenue transforms from “anticipated revenue” into “revenue,” and accounts for every dollar along each step of this journey.
For example, if a customer signs on for an expected $1200 Annual Contract Value at $100 per month, instead of asking for $1200 up front and offering the service to the customer for the full year, the SaaS business can expect to exchange services each month for the price of $100. This means that $100 per month will be recognized by the business until the close of the year.
Tracking recognized revenue is especially critical for SaaS company models because of the nature of subscription-based business, wherein customers are charged for services over a period of time. Following the money as it flows into their revenue stream and understanding when it is officially recognized is pivotal to scaling business.
Two Types of Revenue Recognition
There are two main types of revenue recognition. Their differences lie in when the sale is recorded in a business’ accounts. Let’s take a look at some pros and cons of each:
Cash-Basis Accounting
In this form of accounting, revenue is recognized when a payment is received and added to the ledger. When expenses are incurred, they are subtracted from the ledger. This simple concept is the basis for many small businesses and entrepreneurs with little or no inventory, and does not take accounts receivable and payable into consideration.
| Pros | Cons |
| Business is taxed only when cash hits bank account | Room to misinterpret finances of business doesn’t consider credit purchases/expenses |
| Easy to track liquid cash | Insufficient for big businesses with large inventories |
| Simple to maintain | Challenging to forecast |
Accrual-Based Accounting
In this form of accounting, revenue and expenses are recorded as soon as they are earned, irrespective of when the money actually lands in their account or expenses are incurred. This form of accounting proves to be beneficial for SaaS companies, as it effectively tracks MRR.
While accrual accounting is more complicated than cash-based accounting, it is commonly used by larger businesses or businesses with a sizeable inventory. In fact, businesses which gross over $25 million in receipts each year are required by the IRS to use the accrual accounting method.
| Pros | Cons |
| More accurate depiction of profit at any point | Complex; requires involved bookkeeping |
| Easier to forecast | Business is taxed on money it hasn’t yet received |
(Because income can be reported when a sale is made and not when the actual revenue hits the ledger, a business can be taxed on money it has not yet received.)
Why Do Accounting Standards Exist?
Accounting standards help to hold businesses to a set of legal best practices. One of the Generally Accepted Accounting Principles in the United States (GAAP), revenue recognition is regulated by the Financial Accounting Standards Board (FASB). International accounting, on the other hand, practices International Financial Reporting Standards (IFRS) which is regulated by the International Accounting Standards Board (IASB).
In addition to making it easy for companies to understand their finances, accounting standards allow businesses to compare their financial situation across companies and industries. By standardizing financial reporting, these standards increase transparency and eliminate disparities in the ways a business might run its accounting, which creates a playing field with clear rules and expectations.
ASC 606
Due to the conflicting nature of certain aspects of America’s GAAP regulations with the loosely defined IFRS, FASB and IFRS came together to establish a better revenue recognition standard, named ASC 606.
Effective as of December 2017, ASC 606 encompasses revenue recognition principles across industries in one vigorous, flexible framework. This new standard resolved the previous confusion around SaaS accounting due to unclear regulations and inconsistent practices. Its founding principle is that a business must “recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.”
Some key difficulties a SaaS business might encounter in enforcing this standard include:
- Quantifying termination provisions and variable recognition
- Quantifying select contract acquisition costs
- Identifying service obligations in hybrid cloud-based agreements
- Quantifying the standalone price of software licenses in an agreement
Here are the basic steps for following this standard and avoiding the aforementioned difficulties:
- Identify the customer contract. A mutually agreed upon contract defines the rights and responsibilities of each side. The contract should detail the criteria in either written or oral form.
- Identify performance obligations. This should be delineated clearly as actions or delivered goods within a contract.
- Determine pricing. This sets the price for the considerations within the contract.
- Allocate the price. This describes how pricing aligns with tasks or goods outlined in the customer agreement.
- Recognize revenue as the contract is satisfied. As the customer benefits from a company’s service or product, revenue is recognized over time. This is driven by the transfer of control from a company to a customer.
Non-Refundable Up-Front Fees Under ASC 606
In some SaaS agreements, the customer pays an up-front fee which is non-refundable. ASC 606 requires the business to decide whether the fee is an advance payment for future goods or services, or if it is associated with a promised transfer of goods or services. Once this non-refundable fee has been accounted for, some agreements allow the customer to terminate their policy at their convenience.
Termination Rights Under ASC 606
According to the established standard, if a customer can end a contract without a significant penalty, only the non-cancelable piece of the contract is accounted for. In other words, if a customer can end their relationship with a business at any point and receive a proportional refund, the arrangement should be considered a daily contract. As such, performance obligations that remain undelivered due to the customer’s termination should be excluded from deferred revenue.
5 Prerequisites for Recognizing Revenue
There are five necessary criteria for recognizing revenue. They are as follows:
- Risks and rewards have been transferred from business to buyer. These will not be transferred to the buyer until one month’s worth of service has been delivered.
- Seller has no control over the products sold. This typically occurs after one month of service or customer usage has occurred.
- Payment collection is reasonably certain. Credit cards are one means of collecting revenue that is reasonably assured.
- Amount of revenue can reasonably be quantified. SaaS businesses should be able to match revenue to expenses as per the matching principle.
- Cost of earning revenue can reasonably be quantified. Typically, in SaaS business models the cost of providing services to a customer is negligible unless it is custom.
What ASC 606 means for SaaS Companies
ASC 606 clearly delineates expectations for SaaS model businesses.
For example, if a customer subscribes to an SaaS product in late December for an annual contract and has shared their credit card information and had the funds debited from their account, how does the revenue become recognized?
Because the customer will have used the product for less than half of a month at the end of December, several of the prerequisites will remain unfulfilled. By the end of January, the customer will have utilized the product for over a month, so they will be billed for the second month of service. As the book closes at the end of January, the prerequisites for one full month have been satisfied and the monthly subscription fee can be recognized. Observe the chart below for how revenue can be recognized in December as well as subsequent months.
| Can first month’s revenue be recognized? | ||||
| Revenue recognition | Purchase date: Nov 16 | Books close Nov 30 | Books close Dec 31 | |
| 1 | Have risks and rewards been transferred from seller to buyer? | ❌ | Partially fulfilled | ☑️ |
| 2 | Does the vendor have no control over the product sold? | ❌ | Partially fulfilled | ☑️ |
| 3 | Is payment collection reasonably certain? | ☑️ | ☑️ | ☑️ |
| 4 | Can the amount of revenue be measured? | ❌ | Partially fulfilled | ☑️ |
| 5 | Can the cost of earning said revenue be measured? | ☑️ | ☑️ | ☑️ |
Common Complexities of SaaS Revenue Recognition
Whereas annual revenue can be straightforward, there are multiple scenarios in which revenue recognition in a monthly subscription becomes a little more challenging to calculate. Here are a few circumstances:
- A customer accrues set-up fees for the product
- A customer is unable to pay for the product or services
- A customer requires customer support
- A customer upgrades to a better plan
- A customer downgrades to a lower plan
- A customer utilizes consultation services
- A customer cancels the subscription mid-way
- A customer wishes to customize their service or product
In these scenarios, it becomes necessary to prorate and recalibrate revenue in order for it to be recognized appropriately.
Let’s say a SaaS company offering offers three plans for its subscribers valued at $600, $1200, and $2400 per year, respectively. How will they recognize their revenue for each unique customer?
Annual Plan Revenue Recognition
If a customer opts for the middle plan at $1200/year, starting January 1. While they are billed $1200 an invoice up-front at the beginning of the year, only $100 should be recognized per month. The revenue that has been collected but not recognized is called “deferred revenue,” and this remaining $1100 is placed in a Liability Account. At the end of each month, another $100 is recognized until the end of the year in December, when the entire amount is recognized.
In summary:
- Invoice raised in January = $1200
- Revenue recognized in January = $100
- Deferred revenue in January = $1100
- Revenue recognized in December = $1200
- Deferred revenue in December = $0
Annual Plan Revenue Recognition
| Jan | Feb | Mar | Apr | May | Jun | Jul | Aug | Sept | Oct | Nov | Dec | |
| Revenue | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 |
| Deferred revenue | 1100 | 1000 | 900 | 800 | 700 | 600 | 500 | 400 | 300 | 200 | 100 | 0 |
Plan Upgrade Revenue Recognition
If, assuming the predetermined price points with the beginning contract date of January 1, the customer decides to upgrade their plan to the $2400 premium plan mid-April, their Monthly Recurring Revenue (MRR) for the month of April would be $200. Here’s how the revenue recognition would be allocated:
- Invoice raised in January = $1200
- Revenue recognized until March 31 = $300
- Revenue recognized April 1-15 = $50
- Total revenue recognized January 1-April 15 = $350
- Credit note raised = $850; new prorated invoice = $1700
- Total revenue recognized in April = $150 ($100 for remaining days of service rendered)
- Deferred revenue April 30 = $1600 ($2400 prorated April 15-December 31)
- Revenue recognized for subsequent months = $200
Plan Upgrade Revenue Recognition
| Jan | Feb | Mar | Apr | May | Jun | Jul | Aug | Sept | Oct | Nov | Dec | |
| Revenue | 100 | 100 | 100 | 150 | 200 | 200 | 200 | 200 | 200 | 200 | 200 | 200 |
| Deferred revenue | 1100 | 1000 | 900 | 1600 | 1400 | 1200 | 1000 | 800 | 600 | 400 | 200 | 0 |
Quantity Upgrade Revenue Recognition
If, assuming the original middle-grade plan prices at the annual premium beginning January 1, a customer decides to incorporate 10 more agents at $10 per agent starting May 1, this is considered a quantity upgrade. Here’s how the revenue gets recognized:
- Invoice raised for January = $1200
- Revenue recognized January-April = $400
- Quantity upgraded from 100 to 110 agents at $10/agent starting May 1
- Prorated invoice created for May = $800
- Revenue recognized in May and the following months = $200 ($100 + $10/agent*10)
- Deferred revenue in May = $1400
Quantity Upgrade Revenue Recognition
| Jan | Feb | Mar | Apr | May | Jun | Jul | Aug | Sept | Oct | Nov | Dec | |
| Revenue | 100 | 100 | 100 | 100 | 200 | 200 | 200 | 200 | 200 | 200 | 200 | 200 |
| Deferred revenue | 1100 | 1000 | 900 | 800 | 1400 | 1200 | 1000 | 800 | 600 | 400 | 200 | 0 |
Plan Downgrade Revenue Recognition
If a customer downgrades from the predetermined middle grade plan to the lower plan of $600 per year in mid-April, here’s how the revenue from the downgraded plan will be recognized:
- Invoice raised in January = $1200
- Revenue recognized from January-March = $300
- Revenue recognized from April 1-15 = $50
- A credit note will be issued for $850
- A prorated invoice will be generated for $425
- Total revenue recognized in April = $75
- Revenue recognized May-December $50/month
- Deferred revenue in April = $400
- Deferred revenue in May = $350
Plan Downgrade Revenue Recognition
| Jan | Feb | Mar | Apr | May | Jun | Jul | Aug | Sept | Oct | Nov | Dec | |
| Revenue | 100 | 100 | 100 | 75 | 50 | 50 | 50 | 50 | 50 | 50 | 50 | 50 |
| Deferred revenue | 1100 | 1000 | 900 | 400 | 350 | 300 | 250 | 200 | 150 | 100 | 50 | 0 |
Quantity Downgrade Revenue Recognition
If a customer is subscribed to the medium-grade plan at $1200 per year and decides to downgrade from 10 agents per month to 5 starting in mid-April, this will be considered a quantity downgrade. Here’s how the revenue recognition will be allocated:
- Invoice raised in January = $1200
- Revenue recognized from January-March = $330
- Revenue recognized April 1-15 = $175 ($100 + $50 for the first 15 days + $25 for the last 15 days)
- Credit note created = $850 (8*$100 + $50 for 15 days)
- Prorated invoice raised = $425 (8*$50 + $25 for 15 days)
- Revenue recognized in months May-December = $150/month
- Deferred revenue in April = $1200 ($800 + $400 for 5 additional agents)
Quantity Downgrade Revenue Recognition
| Jan | Feb | Mar | Apr | May | Jun | Jul | Aug | Sept | Oct | Nov | Dec | |
| Revenue | 100 | 100 | 100 | 175 | 150 | 150 | 150 | 150 | 150 | 150 | 150 | 150 |
| Deferred revenue | 1100 | 1000 | 900 | 1200 | 1050 | 900 | 750 | 600 | 450 | 300 | 150 | 0 |
Cancellation With a Refund Revenue Recognition
If a customer paying for the middle grade option of $1200 per annum decides that they’d like to cancel their subscription in April, here’s how the revenue would be recognized:
Cancellation With a Refund Revenue Recognition
| Jan | Feb | Mar | Apr | May | |
| Revenue | 100 | 100 | 100 | 0 | _____- |
| Deferred revenue | 1100 | 1000 | 900 | 0 | – |
Cancellation Without a Refund Revenue Recognition
In the instance that the company is not contractually obligated to offer a refund, here’s how the revenue would be recognized provided the customer was signed up for the middle grade plan and decided to cancel in April:
Cancellation Without a Refund Revenue Recognition
| Jan | Feb | Mar | Apr | May | |
| Revenue | 100 | 100 | 100 | 900 | – |
| Deferred revenue | 1100 | 1000 | 900 | 0 | – |
Shift From Annual to Monthly Plan Revenue Recognition
If a customer decides to switch from the annual middle-grade plan to a pay-per-month plan of the same caliber, their monthly payment is still the same. However, the revenue is recognized a little differently:
- Invoice raised in January = $1200
- Revenue recognized January-March = $300 ($100/month)
- Deferred revenue in March = $900
- Revenue recognized in April = $100
- Credit note raised in April = $800
- Deferred revenue in April = $0
Shift From Annual to Monthly Plan Revenue Recognition
| Jan | Feb | Mar | Apr | May | Jun | Jul | Aug | Sept | Oct | Nov | Dec | |
| Revenue | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 |
| Deferred revenue | 1100 | 1000 | 900 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 |
Metered Billing and Add-Ons Revenue Recognition
In the case of metered billing, a customer pays only according to usage of the product or services. If a customer signed on for the middle-grade plan is obligated to pay a set-up fee for the product and is metered for usage at $50/month, here’s how the revenue would be recognized:
Metered Billing and Add-Ons Revenue Recognition
| Jan | Feb | Mar | Apr | May | Jun | Jul | Aug | Sept | Oct | Nov | Dec | |
| Set-Up Fee | 150 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 | 0 |
| Metered Amount | 50 | 50 | 50 | 50 | 50 | 50 | 50 | 50 | 50 | 50 | 50 | 50 |
| Revenue | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 | 100 |
| Deferred revenue | 1100 | 1000 | 900 | 800 | 700 | 600 | 500 | 400 | 300 | 200 | 100 | 0 |
Revenue Recognition for Writing Off Bad Debts
In the event that a business is unable to collect payment, it may be possible to write off bad debts. In accordance with revenue recognition standards, the bad debt must be recorded appropriately to offset the revenue recorded as part of the sale. When the payment is considered to be unobtainable, the company then has the power to write off the debt.
If a customer is unable to pay from April onwards, the revenue recognition would look like this for a partial write-off:
Partial Write-Off Revenue Recognition
| Jan | Feb | Mar | Apr | |
| Revenue | 100 | 100 | 100 | 0 |
| Deferred Revenue | 1100 | 1000 | 900 | 0 |
| Bad Debts | 0 | 0 | 0 | -900 |
| Net Revenue | 100 | 100 | 100 | 300 |
And for a full write-off, the revenue recognition is as follows:
Full Write-Off Revenue Recognition
| Jan | Feb | Mar | Apr | |
| Revenue | 100 | 100 | 100 | 0 |
| Deferred revenue | 1100 | 1000 | 900 | 0 |
| Bad debts | 0 | 0 | 0 | -1200 |
| Net revenue | 100 | 100 | 100 | -300 |
Key Terms to Know for Revenue Recognition
Being able to compute numbers alone is useless without understanding the concepts backing those numbers. Being able to put the results of your calculations into the appropriate context is crucial for understanding your company’s financial health. Here are some key terms to know like the back of your hand:
- Bookings: This represents the number a customer has agreed to pay for a product or service. These cannot be recognized until the service has been completed or the product has been transferred to the customer. Keeping track of bookings can help a business to predict their recognizable revenue lined up for the future.
- Billings: As it sounds, the name indicates the invoice with the amount a customer is billed over a period of time, whether that be a month, a year, etc. Billings affect the cash flow of a company but are not recognized as revenue until the service has been rendered or the product has been delivered.
- Revenue: In order to comprehend revenue recognition, we must first grasp just what revenue is. Distinct from bookings and billings, revenue can be recognized as soon as the services are rendered and the billed amount has been “earned” and added to the ledger.
- Annual Recurring Revenue (ARR): This amount is the equivalent of what a company can expect to make based on annual subscriptions.
- Monthly Recurring Revenue (MRR): This is the equivalent of what a business can expect to make based on monthly subscriptions.
- Expansion MRR: Additional monthly recurring revenue accumulated from existing customers
- Contraction MRR: Monthly Recurring Revenue lost due to customer discounts, removal of add-on fees, cancellations, non-renewals, and downgrades to lower plans
- New MRR: Monthly Recurring Revenue generated from subscriptions created during an allotted period.
Conclusion
Understanding the concepts surrounding accounting is critical to ensuring your business’ success. Without proper revenue recognition, a company is at risk of losing track of their dollar during the transfer of goods or services to a customer. Accounting for the financial side of the exchange at every step of the process ensures nothing is lost in translation and the business has a full grasp of their financial health and fluidity.
Consider using services like Chargebee, a subscription management platform which not only aids a business in managing recurring billings but also ensures that revenue recognition is globally compliant and in accordance with IASB.
By accounting for resources in a single source, a company moves closer to a solitary basis of truth and minimizes the possibility of error or translation issues. Applications like Chargebee report revenue accurately for growing businesses and allows a business to focus on the bottom line instead of getting lost in the weeds.
Ensuring your SaaS business is ASC 606-compliant is necessary to building a strong foundation for your business. Take the guesswork out of your accounting with professional software or services!