SaaS Revenue Recognition & ASC 606 for Startups

To reflect the true financial performance of your SaaS startup, your revenue must be reported accurately. However, there are various complexities to revenue recognition for a SaaS company, especially when ensuring compliance with industry, U.S., and international financial reporting standards.

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 for the gym up front, the gym does not provide you with service upon payment, but rather for 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 a 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.

The Importance of Revenue Recognition for SaaS Startups

SaaS startups need to follow the revenue recognition standard because it provides a better understanding of what your profit and loss are 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 1 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 of unearned revenue 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!

Cash vs. Accrual Accounting: A SaaS Perspective

The cash basis and accrual basis of accounting are two principal methods used to record transactions for SaaS companies. 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.

For 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 12-month period. At the end of 12 months, Company ABC will have recognized the full $12,000.

What is ASC 606 and Why it Matters to SaaS Companies?

ASC 606 (IFRS 15) is an accounting standard issued by The Financial Accounting Standards Board (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.

A Practical Guide to SaaS Revenue Recognition Under ASC 606

Here’s what you need to know about SaaS revenue recognition under the ASC 606:

Identifying Customer Contracts

A contract is considered under the ASC 606 if it meets various criteria. This includes approval and commitment from both parties, identified rights and obligations, payment terms for the goods and services and probable collectibility. Contracts can be both written and verbal.

Determining Performance Obligations

Performance obligations have to properly identify the goods or services that are being exchanged. For a SaaS company, these often include software licenses, cloud-based services, technical support or another type of professional service. Promises can be either distinct, explicit or implicit, or carry a reasonable expectation.

Setting the Transaction Price

A SaaS should consider several factors when setting the transaction price, per the ASC 606 standard. This includes more than just contract terms and customer consideration, but discounts, rebates, other adjustments and other factors that may be considered when it comes to pricing. Transaction price may also include cash or non-cash compensation.

Allocating the Transaction Price

After determining the transaction price, you’ll need to allocate the transaction price to each performance obligation based on its standalone selling price.

Recognizing Revenue Upon Performance Completion

You can follow these five steps to determine how you should recognize your revenue:

1. Identify the contract with a customer.
2. Identify the performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the separate performance obligations.
5. 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.

Common Challenges in SaaS Revenue Recognition

SaaS companies must navigate various challenges in revenue recognition, including deferred revenue, managing upgrades and downgrades, and having to manage cancellations. The best way to overcome these challenges is to be prepared for them. Make sure you understand the revenue recognition principle and ensure that data is processed in real time so all financials are updated at any moment in time. The right technology and partners can help.

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.

Real-World Examples of SaaS Revenue Recognition

Some common examples of SaaS revenue recognition involve subscription fees, startup fees, usage-based agreements, bundle revenue and contract modifications.

For instance, when recognizing revenue based on a subscription term, a SaaS company could provide a data analytics platform to a user over a term of 3 years at $36,000 total. The SaaS company would thereby recognize revenue of $1,000 per month throughout the 3 years.

If there’s a plan adjustment in the subscription term where the user is either upgrading or downgrading service, the revenue schedule would simply be updated to recognize either the higher or lower price each month for the duration of the 3 years.

The Impact of ASC 606 on SaaS Sales Compensation

Per the ASC 606, sales commissions on SaaS services must be capitalized as assets and amortized over the length of the agreed-upon customer contract. This differs from a conventional model, where sales are treated as one-time expenses.

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. Costs 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 there are no additional commissions, what is the life of the contract? You should make a judgment 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

The 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.

1. 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.
2. 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.

Best Practices for Implementing ASC 606 in SaaS Startups

One of the best things you can do to implement ASC 606 in a SaaS startup is simply to know and understand the standard and what it requires. Beyond this, there are several other things you can do. For instance, it’s important to make sure you have the right billing systems in place to track contract milestones, delivery dates and acceptance criteria to automate revenue recognition. The right revenue recognition software can help with this.

Additionally, ensure that you’re periodically reviewing and updating revenue recognition policies to stay better aligned with ASC 606.

The Future of SaaS Revenue Recognition

SaaS revenue recognition is only likely to become more streamlined and faster with the rise of AI and machine learning. AI and machine learning are poised to have an impact on just about every industry. For a SaaS company, benefits may include automatic revenue calculation based on predefined rules and criteria, reducing the time, effort – and potential for error – when making calculations. Automation can also ensure compliance with standards such as the ASC 606.

FAQs on SaaS Revenue Recognition and ASC 606

What is the difference between recognized revenue and deferred revenue in a SaaS business?

Recognized revenue is the income earned from delivering a product or service, while deferred revenue is a payment that’s received before the service is fully delivered.

How does ASC 606 impact the way SaaS companies report revenue to investors?

Aside from investors wanting to ensure the ASC 606 is being adhered to, it simply provides a way for stakeholders to better understand company performance. This includes revenue and any obligations.

When should SaaS companies recognize revenue for multi-year contracts?

It’s typically best practice to recognize revenue throughout the contract – and not when payment is received. That’s because the company delivers the service over time, so revenue that is recognized will reflect the ongoing service. For instance, for an annual $1,200 subscription, the company would recognize $100 per month as the service is provided over the 12-month term.

How do plan upgrades or downgrades affect revenue recognition under ASC 606?

If there’s a plan adjustment in the subscription term where the user is either upgrading or downgrading service, the revenue schedule would simply be updated to recognize either the higher or lower price each month for the duration of the agreement.

What tools can help automate revenue recognition for SaaS startups?

Various tools can help automate revenue recognition. Some of the most popular include Zuora, Maxio and Chargebee. QuickBooks, Recurly, Sage Intacct and Xero are other popular programs.

How does ASC 606 affect the timing of sales commission payments in SaaS companies?

Per the ASC 606, commission expenses are required to be amortized over the length of the contract. This differs from commission for a one-time expense, which is typically collected all at once.

What are the common mistakes SaaS companies make in revenue recognition, and how can they be avoided?

Common mistakes range from misinterpreting standards to incorrect timing to a lack of proper documentation. The best way to avoid mistakes is to know the ASC 606, follow the best practice accounting principles, and use the right tools and programs to help streamline your operations.

Need Help Navigating ASC 606? Contact Graphite Financial

For more information on navigating the ASC 606 and SaaS revenue recognition, contact Graphite Financial today. As experts in SaaS accounting and revenue recognition, we’ve worked with hundreds of startups to put their financial reporting and accounting on the right track. Learn more about our expert service and flexible pricing models by setting up a free consultation today.