The complications with SaaS revenue recognition

SaaS accounting can get really complicated, especially for enterprise level companies that have large deals and long sales cycles. 

The FASB's criteria for revenue recognition are created to ensure that revenue from businesses is only recognized after a product or service has been delivered but things start to get complex situations like:

• Subscription cancellations mid-stream
• Upgrades or downgrades from a monthly/ annual plan mid-year year
• Upgrades or downgrades from a high tier to a lower tier
• Set-up fees
• Usage-based fees
• Consulting services
• Customization

Now, let’s take it a step further and try to think through revenue recognition with thousands or millions of users and you are calculating revenue based on usage-based data or some type of hybrid scenario with subscriptions and usage combined. You would need to calculate:

• Usage for the month
• Any overages for the month of the spent outside of their plan tier
• Deduct promotional pricing if any
• Group rates if required
• The list goes on

In the scenario above, you would take away a lot of the headache with a modern billing platform that would do all those calculations for you, but you get the idea. 

Keep on reading as we delve deeper into other complications you will run into with revenue recognition.

What is SaaS revenue recognition?

For the readers that are not in the financial department, SaaS revenue recognition is the process of recognizing the monetary value that a company earns from delivering its services to a customer. In most cases, SaaS companies recognize revenue when services are delivered, not when cash is received. 

Before we dive into the details, here are some key concepts and metrics of SaaS revenue recognition. 

Key Concepts and Metrics in Revenue Recognition

Deferred Revenue - Already billed money that you cannot recognize as revenue due to the service or product not being given to the customer.

Unbilled revenue - Revenue that is recognized but due to contract milestones or billing schedules, is not yet billable.

Monthly Recurring Revenue (MRR) & Annual Recurring Revenue (ARR) - Recurring revenue a SaaS business can expect to receive based on monthly or annual subscriptions. Types of MRR to be measured are:

• New MRR: The new monthly recurring revenue earned from subscriptions that were created during the corresponding period.
• Expansion MRR: The additional monthly recurring revenue generated from your existing customers.
• Contraction MRR: The MRR lost due to cancellations, downgrades to lower price plans, non-renewals, removal of recurring add-ons, or even due to customer discounts.

Bookings - Forward-looking metric that typically indicates the total value of the purchased services after both parties have agreed to the services for a given period of time.

Billing deals -  The total amount of cash received from the client.

Revenue - All the money received from a customer after a contact is signed and they have purchased services.

Revenue is recognized when an entity has a reasonable belief that it will be able to collect the revenue. Reasonable belief is based on several factors, including:

• Customer history
• Terms of contract agreement
• The entity's knowledge of the customer's financial situation

In an act to try and remove confusion and accounting contradictions, the FASB and IFRS collaborated to create a new revenue recognition standard, called the ASC 606 Revenue from Contracts with Customers. If you aren’t too familiar with that, let’s have a quick look at it.

What is ASC 606?

In essence, the ASC 606 guidelines help businesses recognize revenue consistently and ease the preparation of financial statements. 

From 2018 onwards, all private and public companies would need to comply with the ASC 606 standards. We have a great blog that goes deeper into the revenue recognition 5-step model here if you are interested to learn more.

Difficulty recognizing revenue for additional services

When providing implementation services, you will typically recognize revenue when the service is delivered. Professional services are different from software subscription services and need to be recognized as such. Professional services are often sold in installments and may include milestones to track progress. 

For annual plans, revenue recognition is straightforward. But the complexity gradually increases when there are modifications to subscription plans such as:

• Cancellation of a subscription mid-stream
• Upgrade from a monthly plan to an annual plan in the middle of the year
• Downgrade from a higher plan ($12000) to a lower plan ($6000)

Complicated revenue types

Set-up Fees

This gets complicated because a customer may pay in advance for the service to be done in the future. 

Licensing

Companies need to be aware of the different types of licenses and how they can impact revenue recognition.

Licensing is a type of agreement that allows someone to use another party's intellectual property (IP) for a set period of time. This can include things like patents, trademarks, and copyrights. When it comes to SaaS, licensing agreements usually involve software.

There are two main types of licenses: 

Term licenses - Typically for a set period of time, after which they expire and the user no longer has access to the software. 

Perpetual licenses - Do not expire and the user has access to the software indefinitely.

ASC 606 requires businesses to recognize revenue for licenses that are being renewed no earlier than the beginning of the renewal period. This means that companies cannot recognize revenue from a term license until after it has been renewed by the customer. On the other hand, companies can recognize revenue for perpetual licenses as soon as the license is sold.

Consultation Services

Consultation services are optional services that you can offer to customers, and they are typically offered on a subscription basis. Late fees are quite common with subscription-based consulting services. 

Bundles and Discounts

Bundles and discounts are a great way to increase sales and are common pricing strategies used by SaaS companies to upsell or attract new customers. However, it's important to understand how they work in order to correctly recognize revenue.

When a customer purchases a bundle, they are receiving a discount for buying the software and services as a package. The discount is applied to the combined value of the two items, not just one of them. For example, if a customer pays $20,000 for 100 licenses of your software and wants to purchase $13,000 for 6 months for consulting services ($33,000), you could bundle them together and give a $5,000 discount ($28,000 instead of $33,000).

Most modern billing software will be able to automatically deduct the discount for you so you can more accurately track monthly revenue and make sure you don't over or under-recognize revenue each month. 

Depending on the nature of performance obligations and how they're fulfilled, SaaS companies have a number of revenue recognition methods to choose from.

Appreciation method - Reduce their gains from selling a product at their appreciated value. 

Sales-basis method - Revenue is recognized when the sale is made and delivered to the customer. Outside of SaaS companies, this is the most commonly used method for revenue recognition. 

Percentage-of-completion method - Used mostly when products or services take a long time to deliver and need and have milestones until completion. 

Completed contract method - Often used when a company has a long-term, legally enforceable contract in place and can allow all revenue and expense recognition to be deferred until the completion of a contract.

Proportional performance - Used when a company has a large number of contracts or plans, and it wants to compare its own performance against the competition.

Revenue recognition can be a complicated process, even for the best accountants out there. The situations above can be complicated but having a solid accounting team by your side along with a modern billing platform will really clear up a lot of these situations for you so you can focus on adding more revenue and growth.