Accounting and Taxes

What is Revenue Recognition Principle?

Under the Generally Accepted Accounting Principle (GAAP), revenue recognition is the condition under which revenue is recognized and provides a way to account for it in the financial statements. It is as simple as it sounds but taking the literal value of it might not be the best way to account for revenue in SaaS businesses.

What is different about revenue recognition in SaaS business models?

In SaaS businesses, the customers pay upfront for a few months (monthly contracts) or for the whole year (annual contracts). But the value of the service is realizable throughout the period of this contract, which means you can’t get too excited at the sight of new revenue.

In SaaS, there's always a risk of the customer terminating the contract halfway. So what you see when you acquire a new customer is cash and not revenue. This cash cannot be recognized until it’s earnt over the period of your customer’s contract.

The journal entry for it would call it a liability instead of a sale. This has a huge impact on the income statement. The cash payment that is collected upfront is deferred.

This means that, whenever an invoice is raised, you would route it through the deferred revenue, which helps point out that there is an advance payment that needs to be recognized for the rest of the subscription period.

Guiding Principles of Revenue Recognition

ASC 606 covers all situations when there is a need for contracts with customers involving goods or services. Hence, all SaaS businesses would fall under this bucket and these revenue recognition practices become important for SaaS businesses to understand.

Under ASC 606, there are 5 main revenue recognition principles. Follow these principles, or steps, for proper SaaS revenue recognition

Step 1: Identify the contract with the customer:

Customer contracts are very straightforward in SaaS businesses. The price and the value exchanged is clearly laid out on the website. However, the contractual terms are liable to changes over time such as

  • When a customer upgrades their subscription

  • When a customer downgrades their subscription

  • When add-ons are purchased.

In many cases, these situations might not require a new contract, only slight modifications to the existing contract terms. For example, updating payment terms or license terms.

Step 2: Identify your contractual performance obligations

Don’t let the term ‘performance obligation’ intimidate you! It simply means the product or service you are delivering to the customer for that particular period. In many cases, it might just be "a month’s worth of access to your service."

Step 3: Determine the transaction price

The sales price of SaaS products is usually predetermined and mentioned clearly on the billing page. However one should be aware of custom enterprise deals such as discounts, rewards, rebates, usage, and other schemes that cause the customer’s contract to deviate from the standard price that is taken into account at the beginning.

Step 4: Allocate the transaction price to separate performance obligations

This is important to realize value for the service provided. In SaaS, the product is delivered continuously hence there is no separate performance obligation. Rather, it's a continuous performance obligation.

To do this, the overall billing value is split and allocated to each month which falls as part of the service agreement. This is similar to the principles of the completion method.

Step 5: Recognize revenue as each performance obligation is fulfilled

This is the end goal where the revenue is recognized. In most cases for SaaS, revenue from contracts is recognized over a period of time, not at a specific point in time. This is because as mentioned above, most SaaS performance obligations are satisfied over time.

Why is the Revenue Recognition Principle needed in SaaS?

The Financial Accounting Standards Board (FASB) controlled how companies earned revenue. However, when software moved to the cloud, SaaS revenue recognition fell into a grey area. A new revenue recognition standard was put up with the help of the International Accounting Standards Board (IASB).

New compliance standards such as ASC 606 jointly developed with (International Financial Reporting Standard) IFRS 15 have provided a solution to account for revenue that fell through the many crevices in the earlier accounting principles for revenue recognition. This new, core principle helps improve comparability with companies that adopt GAAP financial statements for their bookkeeping.

Under ASC 606, now companies can recognize revenue at the time when goods and services are transferred to the customer, in proportion to how much has been delivered to that point. This also changes the perspective of SaaS accounting, by moving it from a cash basis to an accrual basis. This helps to break the chicken and egg problem of collectability and spending money that is not claimed yet.

Non-compliance is not an option as the consequences are severe. In addition to this, even if you want to raise money in the future, investors and VCs look for companies that are compliant.

Knowing these principles leads to a bigger question.

At what point does a performance obligation count as being fulfilled?

Under ASC 606, there are 5 key criteria that must be met for the bills to be recognized as revenue,

  • Risks and rewards transferred from seller to buyer

  • The seller has no control over goods being sold

  • The collection of payment is reasonably assured

  • The amount of revenue can be reasonably measured

  • The cost of earning the revenue can be reasonably measured

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