Every one of us knows accurate revenue recognition is the key when analyzing the financial health of your business. You might have a good grip over revenue recognition and you might do it with perfection but things get really tricky when Software Aa a Service business is involved. Why so? Because things are significantly different here in the SaaS industry. SaaS revenue occurs over a longer period. SaaS businesses may price Software, invoice, and track on a monthly, quarterly, and yearly basis respectively. The problem also lies on the flip side of the coin – on the customers’ side. Customers may move to an upgraded package during the middle of the existing contract or may decide to buy various services together. Again, you find yourself in the middle of a revenue recognition problem. 

Do you want to learn all about SaaS revenue recognition? How is it different from other businesses’ revenue recognition? Why is it so important? And so on, then you are on the right platform because we are going to discuss several aspects of SaaS revenue recognition in this post. So stay tuned and let us have your full attention for a while. 

Table of Content

  1. What is SaaS revenue recognition?
  2. How SaaS revenue recognition differs from the revenue recognition principle laid out by Financial Accounting Standards Board (FASB) and the IFRS? 
  3. How to do SaaS revenue recognition – understand through an example
  4. ASC 606 guidelines for SaaS revenue recognition
  5. Common SaaS revenue recognition issues
  6. How to overcome SaaS revenue recognition problems?

What is SaaS revenue recognition? 

SaaS revenue recognition is an accounting process to convert bookings’ cash into your SaaS business’ revenue. It is an accounting and financial reporting principle to report revenue by recognizing the value of a subscription/contract/transaction over the time period it is earned. 

In other words, SaaS revenue recognition is an accounting method that works on the basis of accounting guidelines – to only recognize or acknowledge the value of an upfront paid fee over the time period it is earned.

For example, you are running a SaaS business and one of your customers pays you an upfront fee of $10,000 for a one-year contract. Accounting principles don’t allow you to recognize this fee whenever you receive it. Rather, you have to recognize this fee for reporting purposes over the period of one year because your customer continues to receive services for one year. 

Let’s try to understand it from another angle. Accounting and financial reporting principles require you to report revenue only when you deliver goods or services. You cannot report cash received in advance for services you have to provide over a particular period of time. So, SaaS revenue recognition is a process that directs you to recognize cash as revenue over a period of time you are bound to provide services. 

How SaaS revenue recognition differs from the revenue recognition principle laid out by Financial Accounting Standards Board (FASB) and the IFRS? 

The FASB and the IFRS laid out two stipulations for software providers before revenue recognition. The first one is customers have full control over the software through contractual rights. Secondly, the customers have the right to operate the software on personal system or have a third party do it on their behalf. 

Both of these obligations were met before the introduction of cloud-based software. Customers used to purchase software and use it according to their own needs. Software companies could record the revenue right after the transaction as both revenue recognition stipulations were met. But not now when software has moved to the cloud. Now, SaaS companies have a revenue recognition problem. Their customers generally book for a year in advance. Companies have cash in their hands but they cannot recognize it because revenue recognition conditions are not met. 

So, that is a real problem for SaaS companies. Therefore, earned cash is not immediately recognized as revenue. Rather, SaaS revenue recognition takes place through spreading cash earned over the delivery period. 

How to do SaaS revenue recognition – understand through an example

The SaaS revenue recognition process is totally different from the revenue recognition of any other business. The SaaS business model revolves around one main idea and that is – to provide software as a service to customers by making the software 24/7 available in the cloud while allowing customers access to that software throughout the delivery period. It is simply against the SaaS business principle to allow customers to own the software, operate it their personal systems, or get a third party to do it. 

On the other hand, customers prepay for the software service for the commitment of receiving the service for a particular time period. There is no point where you can mark service delivery as completed. So what now? Will you report the revenue the very moment cash comes into your hands or will you not report the revenue until the delivery period expires? 

A few years ago, there were no guidelines for SaaS revenue recognition in the FASB and the IFRS. SaaS businesses were allowed to book revenue as they wanted. Now, ASC 606 accounting standards have changed the prior practice. Now, SaaS companies have some rules to follow. ASC 606 accounting standards have laid down steps to follow before revenue recognition of each contract. 

  1. Recognise the contract.
  2. Identify the obligations to provide services.
  3. Determine the contract price such as the subscription fee.
  4. Allocate the total contract price between all the obligations to provide services. 
  5. Recognize revenue whenever your company delivers a performance obligation and book unrecognized revenue as deferred revenue. 

To summarize those five steps – SaaS companies can only recognize revenue after deciding contract terms with a customer when the contract obligations are met. 

Let’s try to understand the whole process through an example. Suppose, there is a SaaS company, SaaS Inc. The company provides different software solutions. A customer purchases subscription for one of its software. The contract price is $2,400 and the delivery time is one year. The customer prepays the whole contract price. Now, should SaaS Inc. recognize the revenue immediately, or should wait for one year for revenue recognition? 

The first thing is to book cash in hand as deferred revenue. Now, the next step is, and the flexible one, to break down the delivery period into smaller timeframes for revenue recognition. The delivery period breakdown is up to the SaaS company. They can break it down into days, weeks, or months. However, 30-days is the shortest SaaS billing cycle and is, therefore, recommended. So, SaaS Inc. will recognize $200 each month as revenue from that customer. 

But, there is still a problem. What do you have to do with the unrecognized revenue? For example the whole amount of $2,400 during the first month of the contract, $2,200 during the second month, and so on. The cash in hand cannot be considered as revenue because service has not been fully provided yet. So, what you have is not revenue earned but deferred revenue or unearned revenue. The amount only becomes earned revenue when the service is provided. Deferred and recognized revenue steps can look like this.

  • Deferred revenue = $2,400 during the first month
  • Recognized revenue = $200; Deferred revenue = $2,200 during the second month
  • Recognized revenue = $200; Deferred revenue = $2,000 during the third month
  • Recognized revenue = $200; Deferred revenue = $11800 during the fourth month
  • And so on until the contract ends.

ASC 606 guidelines for SaaS revenue recognition

ASC 606 has eliminated the complications in SaaS revenue recognition and has simplified the process by laying down a five-step model for SaaS revenue recognition and five criteria for recognizing cash received as revenue earned. 

ASC 606 5-step model for SaaS revenue recognition

If customers buy your services, it means they officially enter a contract with you to avail services offered by you. As soon as this happens, Generally Accepted Accounting Principles (GAAP) require you to comply with ASC 606. You can adhere to its guidelines by following the 5-step model for SaaS revenue recognition. 

  1. Identify the contract terms with the customers – sets the criteria for entering a contract with a customer to provide SaaS services. Both parties must enter the contract by mutual consent and the rights and obligations of both parties are clearly stated. 
  2. Identify the company’s performance obligations in the contract – outlines all contract obligations or deliverables when the company will be providing services paid for in the contract. If the customer buys several services simultaneously, they must be accounted for separately. 
  3. Determine the transaction price – describes how to determine transaction price by considering all important aspects. 
  4. Allocate the transaction price to the performance obligations in the contract – lays down rules regarding the allocation of the transaction price across all performance obligations and the delivery period. 
  5. Recognize the revenue when the company satisfies performance obligations – explains how to recognize revenue over the delivery period when the customer actually benefits from your services. 

So, ASC 606 5-step model simplifies the SaaS revenue recognition. In simple words, ASC 606 requires SaaS companies to enter a contract with a customer, clarify service terms, and identify the price. However, you can record revenue only when you have fulfilled contractual obligations and the refund period, if there is any, is over.

ASC 606’s five criteria for recognizing cash received as revenue earned

ASC 606 also requires SaaS companies to fulfill the following 5 criteria before recognizing cash received as revenue earned. 

  1. Recognize the revenue only when all the risks and rewards are transferred to the customer. Risks and rewards are considered to be transferred only when services are delivered. 
  2. The company has been successfully delivering the services for some time such as a month or more.
  3. The company is sure of the collection of the contract price. This criterion revolves around the collectability of payments. 
  4. The revenue amount can be measured reasonably as this criterion revolves around the measurability of revenue. 
  5. The expenses incurred to generate revenue can be measured reasonably.

5. Common SaaS revenue recognition issues

As we have already discussed that SaaS revenue recognition is complex. Although ASC 606 has simplified it, still there are very SaaS-specific issues regarding revenue recognition. 

1. Various possible subscription scenarios

The first and foremost SaaS revenue recognition problem lies in dealing with various possible subscription scenarios. Revenue recognition for an annual subscription plan is straightforward as we have already seen in an example. You just have to calculate recognized revenue after providing services for a period, such as for a month, and deferred revenue. But there are various other possible scenarios such as;

  • When customers go for plan-based upgrades – for example when a customer upgrades to a Premium plan from a Basic plan. There is another scenario in this scenario as well – when the customer upgrades during the middle of a month. Both of these scenarios complicate SaaS revenue recognition. 
  • When customers go for quantity-based upgrades – for example when a customer upgrades by subscribing for additional quantity-based services such as moving from 5 agents to 10 agents.
  • When customers go for plan-based downgrades – for example when a customer downgrades to a Basic plan from a Premium plan. Again, there is another scenario in this scenario as well – when the customer downgrades during the middle of a month. Both of these scenarios complicate SaaS revenue recognition. 
  • When customers go for quantity-based downgrades – for example when a customer downgrades by lowering quantity-based services such as moving from 10 agents to 5 agents.
  • When customers cancel a subscription while having the refund rights – for example when a customer requests for cancellation and refund of prepaid subscription fees.
  • When customers cancel a subscription without having the refund rights – for example when a customer requests for cancellation but don’t have the pre-determined refund rights.
  • When customers shift from annual to monthly plan cycle or vice versa – for example, when a customer decides to shift from annual to monthly plan cycle. The company has to refund prepaid payments and begin to account for monthly payments. 

2. When simple plans evolve into bigger plans

Another SaaS revenue recognition problem appears when a SaaS company evolves its simple plan into a bigger plan. This often happens when the company introduces more features to attract big clients.  

3. SaaS revenue recognition for additional charges

The problem also arises when a SaaS company charges additional fees such as consulting service charges, set-up charges, add-ons, or any other additional service charges. How SaaS companies should recognize revenue from these additional services is tricky. First of all, they have to ascertain whether any of the additional fees have standalone value to the purchaser. Secondly, they have to see whether transactions are “separate units of accounting” or not. 

4. Hybrid pricing models

If a SaaS company is offering a hybrid pricing model consisting of prepaid or upfront fees and usage-based charges, it has to face some serial problems during revenue recognition. 

How to overcome SaaS revenue recognition problems?

SaaS revenue recognition is complex, time-consuming, and tedious. SaaS companies can use revenue recognition software to uncomplicate a very complicated process. 

1. Chargebee – Subscription Management & Recurring Billing Software

Chargebee is one of the best subscription billing and revenue recognition software for fast-growing SaaS businesses. It is an application that allows you to automate your recurring billing, manage subscriptions, and streamline revenue operations. Chargebee is an all-in-one package that optimizes all your operations including sales, marketing, and financial management to accelerate your revenue. It comes with the following remarkable features. 

  • Automates your billing process by scaling your SaaS. It covers 480+ recurring billing scenarios and helps you easily maintain your billing schedules, invoicing, tax management, and payment methods. 
  • Offers smarter subscription management and assists you in making subscription management seamlessly easy even when you scale. Furthermore, Chargebee allows you to have in place the pricing model of your choice. It can handle whether you charge flat fees or fully customized pricing fees.
  • Guarantees revenue operational efficiency and enables you to discover new revenue potential, decrease churn, investigate revenue, achieve revenue milestones faster, and expand worldwide.

2. Chargify – Billing & Revenue Management for B2B SaaS

Chargify is another SaaS-focused billing and revenue management software that makes SaaS revenue recognition easy. It enables SaaS businesses to create, optimize, and adapt offers to maximize subscription revenue. Moreover, its data analytics empowers you to use a massive amount of data for your competitive advantage. Chargify offers various unique features such as;

  • Handles simple to complex usage, even events-based, subscription scenarios. It ensures flexibility to bill, rate, and invoice according to your own plans. You think about your plans, it will bill it irrespective of your pricing model.
  • Manages subscription from start to finish with precision and perfection. It automates all processes to help you satisfy your customers and accelerate your growth.
  • Keeps your accounting and bookkeeping in the way you want and helps you provide the ultimate transparency. 
  • Data and analytics is another top-notch feature that helps you make informed decisions. It makes you know your revenue stats as well as trends of your products and customer. Diving deep into the vast data helps you get insight and optimize your business operations. 

3. SaaSOptics – Leading Financial Operations in 2021

SaaSOptics is another remarkable tool to supercharge your SaaS revenue recognition and financial operations. It is an extremely popular platform worldwide that lets you automate your revenue recognition process. Besides revenue recognition, it also manages your expenses, sales activities, and also helps you validate your story. SaaSOptics is truly an all-inclusive platform that offers various mesmerizing features;

  • Enables you efficiently invoice your customers, as per your varying term agreements, and receive payments in your accounts earlier than ever before. SaaSOptics automates your order processing, integrates order-to-cash, and does A/R management. 
  • Automates and ensures perfect revenue recognition. It handles SaaS revenue recognition even the most complex revenue recognition scenarios and helps you meet GAAP/IFRS compliance. 
  • Records all the expenses according to GAAP/IFRS guidelines. You can easily account for your expenses ranging from prepaid expenses to sales commission and between miscellaneous to long-term expenses. 

Another remarkable and most commendable feature of SaaSOptics after revenue 

  • recognition is SaaS metrics and analytics. It comes with an enticing feature that lets your track all important SaaS metrics that ultimately assist you in presenting a validated story about your SaaS business. Moreover, its momentum reports paint a very vivid and clear picture of how your business is performing. 

4. Paddle – Revenue Delivery Platform for SaaS

Paddle is another big name in the SaaS revenue recognition software niche. It is helping saas businesses worldwide to significantly enhance global conversions, mitigate churn, ensure compliance, and scale-up. Paddle is among the very few SaaS-focused revenue management tools that are built for executing all SaaS financial activities. The features it offers are really commendable and praiseworthy. 

  • Paddle has expertise in the SaaS revenue recognition process and helps you accurately recognize your revenue, deferred revenue, invoicing, billing, and licensing. 
  • It helps the higher hierarchy of SaaS companies to make decisions about growth with revenue delivery. Revenue delivery is responsible makes you optimize customer acquisition, customer retention, and expansion of customer base. Proficient revenue delivery means growth beyond your imagination. 
  • Provides Paddle Subscribe toolkit to provide flexible subscription models for customers to give your customers options to choose a plan of their choice. It ultimately leads to customer retention and expansion in customer accounts. 
  • Paddle’s financial management is exquisite in radically simplifying financial operations. It brings and reconciles payments, subscriptions, and invoices together to take responsibilities off your shoulder. 
  • Empowers your revenue team to focus on growth and get insights from a single revenue data source. 

5. GoCardless – Made for Recurring Payments

GoCardless is a popular billing and revenue management software that facilitates the collection of both recurring and one-off payments directly from the bank accounts of your customers. It is a versatile tool that is equally good for both small businesses and enterprises. Now, you can effortlessly keep track of your due payments, reduce bad debts, reduce costs, and eventually improve your cash flow. GoCardless offers the following features that demand your attention. 

  • Creates flexible subscription plans for your customers and facilitates your customers in every possible way to receive payments on time.
  • Collects payment details from your customers just for once and then automatically collects payments whenever they are due. 
  • Allows easy integration with other tools for SaaS businesses to ensure easy financial and revenue management.

The wrap-up

SaaS revenue recognition is an accounting process to convert bookings’ cash into revenue within your SaaS business. It is an accounting and financial reporting principle to report revenue by recognizing the value of a subscription/contract/transaction over the time period it is earned. 

Revenue recognition is an important practice in all sectors and SaaS isn’t an exception. SaaS companies are also responsible for accurate financial reporting. They also need to accurately calculate revenue and keep their accounting books updated to prepare financial statements clearly reflecting the financial health of the company. Accurate financial reporting is very important for stakeholders. Inaccurate revenue recognition causes inaccurate financial reporting. Faulty and inaccurate financial reporting ultimately affects a company’s credibility and integrity. If a company’s credibility is tarnished, it fails to attract potential investors. Therefore, SaaS companies should also accurately recognize revenue and should not compromise on accurate financial reporting. 

Although SaaS revenue recognition is complex, SaaS companies can enjoy the following key benefits of accurate SaaS revenue recognition. 

  • Ensures that your financial statements show profit or loss by your SaaS company in real-time. 
  • Ensures to maintain the trust of the existing investors as well as attract the interest of potential investors by presenting a high-definition picture of your company’s financial health. 
  • Ensures to protect your company from fraudulent activities, biases, and manipulations by requiring you to adhere to the latest GAAP and IFRS outlines for SaaS revenue recognition. 

There are various common errors that SaaS businesses make such as reporting all the revenue at the time of booking. ASC 606’s guidelines do not allow you to record the whole revenue. There are various other SaaS revenue recognition errors that SaaS businesses make because of inherent complexities involved in the process. But the fact remains despite all this – SaaS businesses need to ensure accurate revenue recognition. So, how SaaS businesses can overcome SaaS revenue recognition problems and hurdles? The answer is – by using the best SaaS revenue recognition software. There are various tools available now that have the potential to make your revenue recognition effortless and accurate.