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SaaS Revenue Recognition: Understanding the Financial Standard
SaaS Revenue Recognition: Understanding the Financial Standard
Software as a Service (SaaS) companies run a unique business model that is growing at a rapid rate. Current estimates suggest that the SaaS market is growing by 18% each year!
But the financial reporting side of SaaS business models can get messy. The industry prides itself in providing flexible payment options for its users, which is great for customers but a major pain point for finance teams.
New standards for SaaS revenue recognition aim to ease these burdens. Let’s consider what these standards are and how a CFO can help you maintain them.
What Is SaaS Revenue Recognition?
Revenue recognition for SaaS is no different from your typical revenue recognition process. The only difference is most SaaS transactions are recurring and renew after a longer period. Many companies use annual subscription services.
However, with SaaS revenue recognition, that large sum is broken down into smaller increments to fit into the SaaS company’s monthly revenue statements. For example, if a SaaS company has a client that pays $120,000 for an annual subscription, that would appear as $10,000 monthly recurring revenue (MRR).
How The ASC 606 Standard Affects Your Business
This current standard of revenue recognition for SaaS companies was established by ASC 606. This accounting standard was put into place at the end of 2017 to make it easier for businesses to account for large subscription-based revenue.
The 5 Steps For SaaS Revenue Recognition
ASC 606 outlines a five-step framework that every company should use to maintain consistency in its financial reporting.
1. Define the Contract
The new guidelines offer more flexibility and specifications under what denotes a contract. Namely, contracts don’t necessarily need a signature but must be able to prove:
- All parties agree with and approve the transaction
- All parties are fully committed to fulfilling the contract
- Payment terms are clarified
- All parties’ rights are easily identified in the document
- Performance obligations of the company providing services and all associated payment terms are clearly outlined
These criteria are no different from the average contract.
2. Clearly Identify Performance Obligations
Performance obligations refer to the promise you maintain to deliver the goods and services to your client upon receiving payment. Therefore, you need to identify every service your clients are obligated to receive and the timing of the performance and completion of the goods or services.
3. Establish a Price for the Service
How much does the service cost? This will likely be agreed upon before you get to the contract phase, but ensure the total is apparent on the contract. If any upgrades, discounts, service add-ons, or custom pricing options are available, apply those to the total and document why the total was changed.
4. Distribute the Price Among Each Obligation
To justify the cost of the transaction, assign value to each of the contract’s performance obligations. For example, you may split the total amount to be recognized as revenue gathered from each performance obligation.
5. Recognize the Revenue
After the transaction occurs and the client receives your services, you can recognize the revenue in your profit and loss statement.
Challenges Involved With SaaS Companies And Accounting Revenue
While the above five-step process helps streamline and simplify SaaS revenue recognition, that does not mean challenges are non-existent or easily avoided. The reality is the SaaS business model is still new, meaning there are a lot of nuances that create unique challenges. Here are a few challenges you may run into with SaaS revenue recognition.
Cancellations in the Middle of Business Cycles
Many companies will pay for an entire year’s worth of services, only to cancel part of the way through the year. How do you manage that on your financial statements? The answer can be pretty complicated.
If you amortize the payment across multiple months, you must calculate how much of that initial payment was used. For example, if the company paid $12,000 for the annual subscription but only used it for four months before canceling, they’ve only used $4,000. The remaining $8,000 may need to be paid back to the client.
Additionally, you will need to decide if you want to instill cancellation fees for those who cancel before the subscription has run its course.
Upgrades/Downgrades During the Business Cycle
What if a client wishes to change their subscription plan during the cycle? That means the total monthly payment will be different going forward. You will need to adjust the total in the following months based on what has already been paid in previous months.
Usage-Based Revenue and Accrual Accounting
Some SaaS companies don’t use a subscription model and instead charge people according to the services they use. This model is actually incredibly convenient for the client and for your finance team as you can simply record the revenue as you are paid. However, it is not always obvious when you should transition to this payment model.
How A CFO Helps You Overcome These SaaS Challenges
To properly navigate the nuances of SaaS revenue recognition, you need the financial expertise of a virtual CFO. Here’s why:
- Experience with different SaaS models: Virtual CFOs have worked with various industries, meaning they have a complex understanding of how different SaaS models function. They’ll use that understanding to recommend the best SaaS revenue models for your business and industry.
- Proper revenue reporting: Nailing down the revenue recognition model early on is essential for getting your finances in order. If you have the correct numbers in place, your company is in a much better position to grow.
- Understanding of accrual accounting: Accrual accounting is essential for SaaS subscription services. Your CFO will know when it’s right to move towards accrual accounting. But it’s not easy or even recommended to adopt immediately.
- Robust financial modeling expertise: CFOs can more easily build external financial models to calculate even the most nuanced SaaS payment structures. Better yet, these external models won’t be derived from traditional accounting models, so they can more accurately communicate the reality of your financials.
- Knowledge of financial software: In most cases, financial teams start with an Excel spreadsheet to run models and analyze their financials. This works, but you may want to transition to specialized software that automates complex reporting. CFOs will have more experience recommending an ideal time to make the switch.
Get Help With Your SaaS Company’s Books
The SaaS world is hyper-competitive, and you should focus on delivering an experience that transcends expectations. But to meet those expectations, you need a strong financial backbone. A virtual CFO is the easiest way to establish that foundation.
Talk to an Ampleo expert today to find out how a virtual CFO can position your business for greater success.
Rob Lund is a CFO at Amplēo. Rob has served as the CFO for several businesses in the SaaS, e-commerce, and manufacturing industries. He has worked with companies both public and private and at all stages from startup to IPO.
Before joining Amplēo in 2018, Rob worked for 20 years as a CFO, Director of Finance and Accounting, and other positions at several SaaS, manufacturing, and consumer product companies. Rob worked earlier in his career with Grant Thornton, JCPenney, and General Electric. He also held a part-time instructor position at the University of Utah.
Fun Facts/Hobbies
- Skiing
- Enjoys traveling with his wife and daughter
- Reading books about history and business biographies
Education/Certificates
- Earned a Master of Liberal Arts in Management with an emphasis in Finance from Harvard University
- MBA from Westminster College
- BS in Accounting from the University of Utah
- Certified Lean-Six-Sigma Black Belt
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