Growing a SAAS business is exciting — especially when you see all the cash rolling in. Knowing how to account for this revenue can be tricky.
Do you account for these invoices and funds as they are received, or do you allow a buffer period? While these questions might seem straightforward at first glance, a couple of other factors can affect revenue recognition.
You must understand when your company recognizes revenue. If your account for the money from your contracts as revenue inappropriately, you’ll risk having an inaccurate understanding of your company’s actual profits.
If you’re in the software-as-a-service (SaaS), you’ll want to understand how to manage SaaS revenue recognition properly. You might already know that revenue recognition is tricky, challenging, and complicated.
However, the complexity of the topic doesn’t mean it shouldn’t be done correctly. This post will cover everything you need to know to manage your SaaS revenue recognition for your startup.
What Is Revenue Recognition?
Revenue recognition is the process of accounting for revenue in the period it’s earned. It is essentially when revenue is recognized and brought into the company’s income statement.
From a more technical standpoint, it involves evaluating which transactions should be recorded as sales and when they should be recorded.
Revenue recognition can be complicated for SaaS businesses because they usually provide software as a service instead of a single product. They also offer subscription services that are typically paid regularly. Because of this, it’s difficult to determine when revenue has been earned and can be recognized.
Proper revenue recognition is essential because it has a significant impact on how much money you’re bringing in, how well you’re doing compared to past months/years, and what kind of information investors can see about your startup. For this reason, revenue recognition is essential for understanding how well a business is doing financially.
To help you understand how revenue recognition can be tricky, consider this. You have a customer who agrees to pay you for a service subscription of $1,000 each month for a yearly contract worth $12,000. Should you recognize the $12,000 right away? The answer is no.
Your revenue can only be accounted for once the service has been delivered in totality and when the obligations have been met. In this case, only $1,000 in revenue can be recorded each month until the contract expires.
This is where the problem lies with revenue recognition for SaaS companies and stems from the fact that it’s not always an easy process.
Companies often have to judge complex contracts and decide when and how to record revenue. This leads to companies using different methods for revenue recognition, which creates an inconsistency in their reporting.
Monthly Recurring Revenue (MRR) & Annual Recurring Revenue (ARR)
You’ll often hear two terms when talking about SAAS revenue recognition: Monthly Recurring Revenue (MRR) and Annual Recurring Revenue (ARR). These are both essential metrics for understanding your business and its growth.
Monthly recurring revenue is your customers’ subscription revenue each month. It does not include one-time fees or usage-based fees.
Annual recurring revenue is the same as monthly revenue, but it is calculated every year instead of every month.
When you multiply your monthly recurring revenue by 12, you get your annual recurring revenue.
Bookings are the total dollar value of a new contract or renewal. They include any money that you have contracted for in the future.
For example, if you sign up a new customer for $500 per month and commit to one year of service, it’s not just $500 this month that you can count on as revenue. You can count on $6,000 for this customer over the next 12 months (more if they renew at the end).
The reason that bookings are so essential is that they help you predict your company’s future revenue. Revenue (also called ARR) is excellent because it gives you an idea of what money is flowing into your business.
However, bookings are like a crystal ball into the future and provide you with insight into what is likely to happen later based on what has happened so far.
Bookings can forecast future revenue and show investors how much money your company has “booked.”
This can be useful when pitching potential investors since it shows them how much money your company has effectively contracted for with its customers over a set period. This also gives them an idea of how much revenue they can expect from your company in the future.
Billings is the revenue that your company brings in during a particular period. This can be tracked on a monthly, quarterly, or annual basis. Billings can also be defined as the revenue recognized in a given period that has not yet been paid for.
Many SaaS companies refer to billings as the new revenue they book during a given period. While revenue is the money you’ve earned through selling products or services, billings is the money you’re bringing in through the sales team.
For example, if you sign a customer to a six-month contract worth $1,200, you’ll receive $200 per month. Your revenue is $200 per month for six months for $1,200. However, your billings are $1,200 since that’s the amount of money you bring in from the sales team.
Revenue is the total amount of money a company receives from its customers in exchange for the sales of goods or services. Revenue is often referred to as the “top line” because it sits at the top of the income statement. The term contrasts the cost of goods sold (COGS), operating expenses, and other expenses that make up the bottom line on an income statement.
The three main types of revenue are recurring revenue, project revenue, and transactional revenue.
Recurring revenue comes from a consistent source, often from subscription-based products or services; project revenue is based on the delivery of a one-time service, and transactional revenue is typically fee-based for each transaction.
The difference between revenue and billings is straightforward — it’s just the timing of when you recognize them on your financial statements. Revenue is recognized immediately when earned, while billings are recognized immediately when billed (but before actually being paid).
It’s important to note that revenue recognition doesn’t mean cash received. For example, if you record $100,000 in revenue for a month but haven’t yet received any money from your customer for that work, it’s still recognized as revenue. In this case, you’d have an accounts receivable balance until the customer paid.
It’s also important to know that revenue is not the same as profit. Profit is the amount of leftover money after you deduct all the cost of goods and expenses from your income.
Key Guidelines for SAAS Revenue Recognition
Startups typically have a lot of things to worry about when it comes to revenue recognition.
Fortunately, the Financial Accounting Standards Board (FASB) has provided some key guidelines for SAAS revenue recognition that can help ensure your business appropriately recognizes revenue by Generally Accepted Accounting Principles (GAAP). They are based on these five steps:
Step 1: Identify the contract terms.
Step 2: Identify the entity’s performance obligations in the contract.
Step 3: Determine the transaction price.
Step 4: Allocate the transaction price to the performance obligations in the contract.
Step 5: Recognize revenue when (or as) the entity satisfies a performance obligation.
Key Concepts and Metrics in Revenue Recognition
Now that you’ve got a handle on the basics of revenue recognition, let’s look at some key concepts related to revenue recognition.
Deferred revenue is the money a company has charged its customers for products or services but has not yet delivered.
Deferred revenue is also called unearned or advance income because it occurs when a company receives payment for goods and services that have yet to be delivered.
These goods or services will be delivered in the future, at which point the deferred revenue will then become earned revenue. Deferred revenue is considered a liability on a company’s balance sheet until the obligation is fulfilled, which becomes earned revenue.
For example, if you have a subscription-based business model and charge your customers upfront, you will have both earned and unearned revenue on your balance sheet. Any prepaid subscriptions that you have not delivered yet are considered deferred revenue.
Deferred revenue, or deferred income, is a payment from a customer that has been received by the company but not yet earned. Every time you receive money from a customer, and it’s not yet earned, you need to record it as an asset called “deferred revenue” on your balance sheet. Deferred revenue is considered a liability because it’s an obligation to provide services to your customer in the future.
You’re a software company, and you sell 12-month subscription licenses for $120 per year per user. Your customers pay you upfront before they even use your software. Since they paid you in advance before using your software, this revenue is considered unearned until the services have been provided.
When you receive the money from your customers, you’ll recognize this on your balance sheet as deferred revenue since it represents payments for future services that have not yet been performed.
As soon as your customers start using your software, at the end of each month or quarter, depending on how often you bill them, you’ll recognize some of that deferred revenue as earned revenue by recording sales on your income statement and reducing deferred revenue through journal entries. You’ll continue to do this each month or quarter until all deferred revenue is recognized as sales.
Unbilled revenue is the value of a signed contract or service yet to be performed. It is also known as deferred revenue, and it is listed on the balance sheet. The income from products or services sold on credit has not yet been billed to a customer.
For example, if a company accepts payment for an annual subscription of $10,000, unbilled revenue will be recorded under liability in the balance sheet.
However, if the company provides the service each month throughout the year ($1,000), $1,000 will be moved to income (after adjusting the liability). The remaining amount in unbilled revenue will still be available to increase revenue when the next month’s services are provided.
The most common way for software companies to generate unbilled revenue is when customers prepay for the service. For example, if a customer signs up for a year of service for $1,200, the company gets paid $1,200 upfront. However, the company can’t recognize that total amount of money as revenue on the income statement because it hasn’t earned it yet — it has to recognize it as revenue over time.
What Is Accrual Accounting?
There are two basic types of accounting methods: accrual and cash-based. Cash-based accounting records transactions when the money changes hands, whereas accrual accounting records transactions when the deal is agreed upon.
For example, if a SaaS startup bills a customer in December, but your customer doesn’t pay until January, a cash-based accounting system would record the transaction in January, but an accrual system would have recorded it in December.
Accrual accounting makes more sense for long-term projects or businesses paid in advance (such as subscription services). If a company signs up 1,000 customers to a subscription service and receives all of the payments, they need to be able to track how much money they’re earning overtime to pay their bills and gauge their growth.
How to Recognize the Three Types of SaaS Revenue
Businesses can generally earn three types of SaaS revenue, i.e., license or user fees, support, and projects. Each of these revenues has specific contract types and obligations, so your business needs to recognize them.
License or User Fees
License or user fees are what you charge your customers for using your software. Companies that use this system charge per user or seat, and license fees are the most straightforward when it comes to accounting, as they receive payment upfront for the use of their software as a service.
Often these companies will provide tiered pricing schemes based on different service levels, with additional fees tacked on if users exceed storage or bandwidth limits. And some set usage caps at all.
These are usually charged monthly (or annually) per user. If you offer different editions (e.g., Professional vs. Enterprise vs. Ultimate), these will be priced differently.
The main advantage of this revenue model is that it’s scalable. You get paid every month for as long as your customers use your software, and if more users sign up to use your service, your revenue will increase.
In addition to software licenses, many SaaS companies offer customers support services or technical support at a cost.
One-time fees can be charged for services like onboarding, training, and additional features that aren’t included in your customers’ subscription plan but are necessary for them to use your service effectively.
Projects are one-off charges for custom programming or other non-subscription work within an existing contract. For example, if you have a customer who wants to add new functionality to your product and agree to build it for them, you’ll probably bill them separately for that work rather than just adding it to their next renewal cycle.
Aligning COGS With Revenue Recognition for SAAS Companies
Proper revenue recognition is a critical component of a company’s financial statements. It enables investors, management, and the board of directors to make informed decisions about the future direction of the business.
SaaS companies have to synchronize all costs of goods sold with the recognition of revenue to get a clear picture of the company’s earnings and spending.
Key Challenges of SAAS Revenue Recognition
Revenue recognition is a critical part of your startup’s financial health. With the increasing popularity of SAAS (software as a service) and other subscription-based business models, it can be a significant challenge to manage revenue recognition accurately.
The challenges of managing revenue recognition for your startup include:
Correctly calculating the sale value: It’s essential to correctly calculate the sale value to make sure you’re charging the right amount for your software. This includes ensuring you aren’t undercharging for your product or overstating its capabilities.
Timing of revenue recognition: When you sell a new version of your software, there may be delays between when you start selling it and when you recognize that revenue because there may be different stages in your product’s development cycle where it could take longer than expected to get from one location to another.
The Easiest Way to Ensure Your SaaS Revenue Is Recognized Correctly
As a SaaS company, you’re probably all too familiar with revenue recognition, as it’s one of the trickiest concepts in accounting and a major topic of discussion. The rules for revenue recognition have changed dramatically in recent years, thanks to new guidance from the Financial Accounting Standards Board (FASB).
The easiest way to ensure your SaaS revenue is recognized correctly is to work with an experienced accounting team. It’s best to work with an experienced accounting firm that has experience managing software revenue recognition.