Revenue recognition is increasingly important for scaling SaaS companies. We’ve covered this topic before so we decided to outline revenue recognition for you again below but if you’re just interested in the key challenges of revenue recognition skip to the last section.
WHAT IS REVENUE RECOGNITION
Revenue recognition is an accounting principle that highlights standard conditions for when income can be reported and how accounting should manage it (for more on this go here). It can appear complex so many organizations now resort to revenue recognition software that can aid this process.
WHY IS IT IMPORTANT
It’s a uniform framework in which to work towards, but impacts the performance of the business as a whole; it’s not just for the accountants. This is why many organizations now choose to operate it from their chosen CRM system so all business functions can provide the accurate data to feed this metric. For example Revenue Recognition in Salesforce makes up significant functionality in their CPQ product.
But furthermore, it’s important as it marks the point when sales becomes revenue. Any delay to that point can therefore significantly impact the bottom line, which is why it is a Generally Accepted Accounting Principle (GAAP).
WHAT ARE THE TYPES OF REVENUE RECOGNITION
Cash basis - a simple accounting method of recognizing revenue when you receive it, as in when you’ve been paid. Expenses can simply be minused off this. This is good for smaller businesses as they can declare money as it enters and leaves the company and then they don’t have to pay tax on money they didn’t actually have in the account.
Whilst the simplicity is good, this method does make forecasting difficult and if your inventory scales with your business then it’s harder to keep track.
Accrual - both revenue and expenses are accounted for when booked, not when they are paid, making accurate tracking of monthly recognized revenue (MRR) possible. This is better for larger organizations, not least as it is an IRS stipulation if you earn more than $25 million gross per year.
SO WHAT IS ASC606 & IFRS15?
This is the accounting standard for revenue recognition as compiled by the FASB and IFRS so there is a standardized framework. ASC606 is good revenue recognition for SaaS organization as financial statements can be simplified, using five stages.
THE FIVE STAGES OF REVENUE RECOGNITION FOR SaaS
Identify the contract with the customer by outlining the criteria for creating the contract and the mutually agreed upon obligations of both parties.
Identify the obligations that form the contract, describing all performance requirements and deliverables. If services or products are separate, the accounting of them also needs to be distinct.
Agree on the transaction price and the considerations of the individual charges. List all revenue streams including initial ones and those that are to be received incrementally.
Allocate the transaction price at the inception of the contract. All items must have a stand-alone value i.e. the cost it would be should it be sold separately.
Recognize Revenue as the customer benefits from your product or service. When the customer has control of it, you can recognize the revenue.
KEY CHALLENGES OF SaaS REVENUE RECOGNITION
Subscription model | if your customer subscribes annually to your SaaS product revenue recognition is easy. But it gets complicated due to the degree of flexibility provided, such flexibility becoming commonplace. If the customer cancels the annual subscription before the year is out you may have to provide a refund, credit note or recognize revenue as deferred. Alternatively, if no refund is due you can bring forward the revenue instead of recognizing it incrementally. Either way it complicates the way revenue is recognized.
Switching from monthly to annual | if people are paying monthly for your software you can recognize that revenue monthly and forecast future revenues on that basis. But if they then decide to switch to an annual plan at a non-convenient time, for example in the middle of a tax year, the accounting process will have to take into account services received in days, when the switch is, calculate deferred revenue and then they will have to hold a prorated amount. Similar actions have to be taken into consideration if a customer chooses to downgrade their account, although this time revenue recognized will have to be reduced.
Time-consuming and prone to error | tracking revenue from invoices to spreadsheets is not only dull but the volume of data is high. In transferring line items mistakes can be made that lead to incorrect data that maps into your figures for revenue recognition (which can lead to problems with the tax man). Plus as you grow your customer base the process is time-consuming and the errors more likely to occur. Even small errors can impact your records in a big way. Ensure you get out of spreadsheets and into a system that records the information accurately and with a degree of automation.
Some software misses key SaaS metrics | subscription models are the norm for SaaS companies these days so you’ll need software that tracks those key metrics important to your business like recognizable revenue, deferred revenue and unbilled accrued revenue.