SaaS Revenue Recognition: What to Know
Sam Patel, Manager at Graphite
April 27th, 2020
In this article, we will discuss revenue recognition, ASC 606, and why revenue recognition matters for SaaS startups.
What is Revenue Recognition?
Revenue recognition is an accounting method that matches revenue to the periods the services are provided. Think about this example: you pay for an annual membership to a gym. Although you pay the gym up front, the gym does not provide you service upon payment, but rather over the course of an entire year. Revenue recognition is very important, especially for large contracts and upfront payments, where the customer pays the contract in full before receiving the whole service, as is the case for many SaaS businesses.
Revenue recognition is a generally accepted accounting principle (GAAP) and key principle of accrual basis accounting for SaaS that requires revenue to be recognized when services or products are provided to customers, regardless of when the payment is received. Another example: A $240,000 annual subscription fee would simply be recognized using accrual accounting as $20,000 per month.
What is the difference between cash vs. accrual accounting?
The cash basis and accrual basis of accounting are two principal methods used to record transactions. The core difference between the two methods is in the timing of when revenue and expenses are recorded. Cash accounting recognizes revenue and expenses when revenue is received and expenses are paid, but accrual accounting recognizes revenue and expenses when they are billed and earned, regardless of when money is received.
Example – Under a cash basis of accounting, Company ABC invoices a client for an annual, one-year subscription for $12,000. Company ABC records the entire $12,000 in a single month in the financial statements.
Under an accrual basis of accounting, Company ABC invoices an annual, one-year subscription for $12,000. Company ABC recognizes $1,000 a month over a twelve-month period. At the end of twelve months, Company ABC will have recognized the full $12,000.
Why is revenue recognition important for SaaS Startups?
It is important for SaaS startups to follow the revenue recognition standard because it provides a better understanding of what your profit and loss is like. If a company records revenue when the customer makes an upfront payment, then the financial statements will show more profits than they actually earned in that period. The revenues that were previously recorded too early will now be missing from future periods, causing those financial statements to have lower profits.
Again, let’s go back to the example of the $240,000 annual subscription. If the business was to record the $240,000 on January 1st as revenue all at once, they’d still be providing service in December but seeing no revenue, or “benefit”, from that service on their monthly P&L.
Incorrect income reporting can cause ripple effects that change current and future financial reports, creating misleading financial statements. And steering your ship using a misleading map can be dangerous!
What is ASC 606? How do I decide how to recognize my revenue under ASC 606?
ASC 606 (IFRS 15) is an accounting standard issued by The Financial Accounting Standards Boards (FASB) in a collaborative effort with the International Accounting Standards Board (IASB) on how companies recognize revenue from customer contracts. Before ASC 606, the revenue recognition process had traditionally been inconsistent across industries and companies. With this new set of rules, there is now a standard process that details how companies across industries are expected to recognize revenue.
If you’re a startup reporting to investors, they will likely want to see this new standard implemented.
How do I decide how to recognize my revenue under ASC 606?
You can follow these five steps to determine how you should recognize your revenue:
- Identify the contract with a customer.
- Identify the performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the separate performance obligations.
- Recognize revenue upon satisfaction of the obligation
Startups need to reevaluate their current tech stack for billing and other supporting systems to see if they can provide accurate and efficient reporting under ASC 606. Sales, Legal and Finance teams all need to work collectively to define processes that allow growth without compromising compliance. Finance teams should know ASC 606 and help the sales team understand how the new rules impact services offered and compensation plans. Finance and Legal teams need to work collectively on the contract verbiage and content that might ease the requirements of the new regulations.
What is deferred revenue?
Deferred revenue is a payment for future services that have not been performed and therefore cannot yet be reported on the income statement. These payments are classified on the company’s balance sheet as a liability and not as an asset.
Going back to our example of the $240,000 annual subscription, when the invoice is sent to the client, the $240,000 is recorded in full as deferred revenue, aka a liability, because you still owe the client a year of service. After one month of service, your deferred revenue would go down by 1/12 to $220,000 as you transfer and record $20,000 as revenue.
How does ASC 606 affect sales compensation?
1. Capitalizing Costs
Within ASC 606 is a sub-chapter (ASC-340-40-25) that indicates how costs related to getting a new contract should be capitalized. Cost such as travel expenses will occur whether or not a sale is made, and therefore should be expensed. Sales Commissions only occur if a sale is made and therefore NEED to be capitalized and amortized over the life of the contract.
2. Contract renewal
In subscription economics, most companies pay commissions when the customer first signs the contract. When a customer renews the contract, there is little or no renewal commission paid to the salesperson who got the initial contract. In this situation, there are two points to consider:
Do you pay additional commissions when renewed? How much?
If no additional commissions, what is the life of the contract? You should make a judgement call to determine how long the customer is expected to stay. The commission should be expensed over the expected life of the contract and not the initial contract length.
3. Practical expedient clause
Cost of acquiring a contract can be expensed immediately if the amortization period is less than one year. It is an option that your accounting team can choose to expense entire commissions immediately. If you choose this option, you MUST be consistent and all contracts that are less than one year must be expensed immediately.
4. Timing of commission payments.
The timing of actual payments does not affect when the cost should be capitalized, nor does it impact the amortization schedule.
5. Amortization Schedule
This is a 2-step process.
- You need to determine the commission cost for each performance obligation in the contract. If the contract indicates multiple obligations to the customer, then you will have to calculate how much commission is paid for each obligation separately.
- For each performance obligation in the contract, you need to recognize the commission cost only when the revenue associated with the obligation is recognized. The schedule for commission amortization MUST match the revenue recognition schedule.
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Born out of a VC fund, Graphite fully understands the strategic and financial needs of high growth companies. If you need accounting support or simply have a question about accounting at your company, feel free to connect with us!