What is Revenue Recognition in SaaS Accounting? [+ 2020 Definition]

If you’re a founder that just wants to grow your SaaS business, the last thing you want to think about is how to report money you’ve already collected. You’re just happy to have cash in the bank.

However, if you want to keep your lawyer or accountant off your bank, giving this article a quick read is a smart move.

We’ll focus on the basic principals of saas revenue recognition that you need to follow to ensure your accounting is done the legal way as defined by The Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB).

These organizations exist so that all SaaS companies report revenue the same way making it easy to compare multiple companies against each other. This standardization is good for the growth of SaaS as an industry.

5 Simple Steps To Make Sure Your Following New Accounting Standards from the FASB and IASB

1. Do you have a new contract with a customer?

This could be on paper, verbal, or completed when the customer paid on your website without talking to anyone on your team. Make sure you look at all your potential revenue streams.

2. What exactly did the customer buy (Fancy way: Identify Performance Obligations)

Did the customer buy a software subscription and prepay for 12 months? Did they purchase consulting or a separate one time set up fee? Splitting this out is the most critical piece of the new rules. We’ll talk more about this later.

3. How much did the customer pay in the transaction?

What is the total size of the contract? Depending on your revenue model, you may have 100’s of different price points depending on what period of time the customer paid for. Include subscription fee’s, one time payments, consulting revenue, and any other items included in the transaction.

4. Split up what the customer paid for

How much of the transaction price is subscription revenue that adds to your MRR? How much of the selling price is professional services or one time fees? Could the customer purchase consulting from you without purchasing the software? To figure out recognized revenue and your true ARR, you’ll need to split up these transactions when new customers sign up.

5. Cash is not revenue. You count revenue when you actually deliver the product (performance obligation)

If a reseller helps you land a new customer that pays $12,000 for your software, and another $5k for a separate consulting fee (that they could get without having to pay for the software), you don’t recognize this revenue on a straight line basis where you just divide by 12 months. Instead, the $12k is recognized $1k/mo and the $5k consulting fee would be spread out across however long it takes you to complete the consulting.

This part is kind of confusing so lets dive into each piece in more detail.

How Much SaaS Revenue Are You Actually Doing According to ASC 606?

The ASC 606 and IFRS 15 are big fancy names that mean something very simple: The way you measure revenue at your SaaS company will need to follow these new standards.

They help answer the simple question: If a customer pays me $24,000 today for a years worth of my product along with a $5k setup fee, how should I report this in my financial statements?

Even though this cash hit your bank today, cash is not revenue.

What these new standards try and outline is that cash collected can only be recognized as revenue when you actually meet a performance obligation.

If the $24,000 annual transaction price was paid upfront, you meet 1/12th of the performance obligation when one month passes.

This means each month you’d report $2,000 in “revenue” on your accounting statements like your Profit and Loss statement you share with investors.

How Should Your SaaS Company Change its Financial Reporting?

If you’re a private saas company, you’ll need to follow these new rules from FASB and IASB. The SEC will enforce these revenue recognition standards across public companies as well.

Lets look at another example where a SaaS company has a selling price of $120,000. The customer is paying to use the software for 2 years. Many software companies bill using a similar software license structure and business model.

For each monthly reporting period the company would report $5000 in revenue until the full 2 years pass.

How Should You Handle Set Up Fee’s or One Time Payments?

Lets say that same SaaS company requires a $20,000 one time setup fee for the new customer paying $120k for 2 years use of the software.

We call this an up-front fee and the new ASC 606 rule enforced by the FASB and IASB wants you to count this as revenue in two different ways depending on how you sell it:

If the software company offers this set-up fee, consulting fee, or customization fee and does not require that the customer also purchase the software, the $20,000 fee is considered a separate performance obligation or a separate unit of accounting. If the consulting or set up takes 4 months to complete, you’d recognize $5,000 per month for each month.

However if there is no way for a customer to purchase the consulting or set-up fee without also purchasing the software, then this is not considered a separate performance obligation and should be recognized as revenue over the same time period as the software contract, 1/12th each month for the year. $20,000/12 is $1,666 per month.

3 Real Examples of How SaaS Accounting Works Today:

Orgzit signed a customer up in 2019 for 10 seats at $100/mo and upgraded that customer to 100 seats at $1200/mo. The customer pays monthly. Orgzit will recognize this revenue as $1200 each month since. This example isn’t confusing because the customer is paying cash at the same time Orgzit is delivering the software value (monthly).

Jivochat has passed $8m in revenue and gives discounts to customer when they pay in advance. Customers pay $18/mo on average but when they pay annually upfront they pay $200 (a $16 discount). Jivochat should recognize this revenue as $200/12months or $16.67 each month.

Infusionsoft (now Keap) used to have 8% monthly churn before adding a required set-up fee for every new account. This setup fee was directly tied to the customer also buying a $200/mo subscription for a year. The setup fee is $600. Keap should recognize this revenue as $200/mo + $600setupfee/12months = $250/mo.

In summary, thew new rules are nothing to be scared about. You shouldn’t have to spend thousands of dollars paying lawyers and accountants to help you understand them. Simply follow the 5 steps at the top of this article and you’ll be in good shape. Then, turn your focus back to optimizing all the important SaaS metrics and remember: never run out of cash!