SaaS Revenue Recognition: The Ultimate Guide

Revenue recognition is inescapable.

Regardless of your industry, every company that deals in customer contracts should know how and when to recognize revenue. 

But counting revenue should be easy, right? A customer pays for your product or service, cash lands into your bank account and you simply update your accounting books with your newfound revenue. 

Unfortunately, that's not how things work. Money paid doesn't mean money earned. SaaS businesses deal with multi-year contracts for a wide range of products and services under a single agreement. 

Not all this money is recognized in a single year. But what happens if you count all your money as revenue for the year? 

• Wrongly recognized revenue causes overvaluation. Since the product/service has yet to be delivered, unearned revenue is shown as a liability. Aggressively recognizing this revenue artificially inflates your reported sales and profits. 
• Wrongly recognized revenue misinterprets the company's actual cash position and ability to fund operations.
• Wrongly recognized revenue overstates the true value of the business and results in incorrect earnings reports to investors or other business holders. 
• Wrongly recognized money is considered a fraudulent activity, and your business can be charged millions as a penalty. 

All of these overvaluation challenges multiply when businesses encounter refunds, returns, and cancellations. Thankfully, the latest ASC 606 standard simplifies a lot of accounting principles, especially for SaaS, for smoother revenue recognition. 

While revenue recognition and reporting guidelines may be inherently complex, we will break them down into simpler terms, so you know exactly what ASC 606 means for your SaaS business. 

TL; DR:

• The revenue recognition standard (ASC 606) states that a business can only recognize revenue when it is earned rather than when the payment is made. 
• Accurate revenue recognition is essential to avoid overvaluing sales and profits, which is considered fraudulent and can lead to penalties and brand damage. 
• The key challenge in recognizing revenue in SaaS is that companies often provide multiple products and services to customers with added benefits like discounts, rebates, and price concessions. Therefore, there is no straightforward way to recognize revenue. 
• The five-step revenue recognition framework of ASC 606 simplifies revenue recognition. It’s an industry-agnostic process that all businesses, SaaS and otherwise, can use to recognize revenue. 

What is revenue recognition? 

Revenue recognition is an aspect of accrual accounting that stipulates when and how businesses “recognize” or record their revenue. The principle requires that businesses recognize revenue when it's earned (accrual accounting) rather than when payment is received (cash accounting).

Both events are usually independent. However, in some businesses, one event frequently happens before the other. Let's look at three different situations to understand revenue recognition practically:

1. Immediately upon receiving payment

This is the simplest form of revenue recognition. You deliver the product/service and immediately get paid. You can instantly record the money received as revenue. This is most common in retail shops or for one-time purchases. 

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2. After payment is received 

When a customer pays upfront, revenue is recognized equally over the term of their contract (quarterly, half-yearly or annually), not when the booking amount (the value of the contract signed) is received.

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3. Before the payment is received

Revenue can also be recorded after the delivery of the product/service but before the payment is made. It's pretty common in service-based agencies where payment is made after service is delivered. So, businesses don't have to wait until payment is collected to record it as revenue. 

The key challenges in SaaS revenue recognition

Revenue recognition is notoriously difficult for SaaS companies to keep up with GAAP and constantly evolving regulations. Software and technology companies often provide multiple products and services to customers with added discounts, rebates, price concessions, and even individual pricing for special customers. 

The basic idea behind "revenue recognition" is that "booking" cannot be considered "revenue" until you have delivered a product/service for which your customer has paid. 

Let's visualize what that means:

Suppose you create an invoice for $6,000 for ABC Pvt. Ltd. in January. If we report this in a traditional way, here's what the revenue schedule would look like:

• End of Q1: $1,500
• End of Q2: $1,500
• End of Q3: $1,500
• End of Q4: $1,500

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Simple, isn't it? But that's not how SaaS businesses work. Every SaaS business is unique from another. So, the intricacies involved in SaaS subscriptions make it challenging to recognize revenue. 

What happens when:

• Subscriptions get canceled. 
• Discounts and charges related to add-ons, training, etc. get implemented. 
• Non-payment of service
• Customer upgrades or downgrades from their plan
• Business offer usage-based pricing 
• Company offers wide variety of contract types

Under these circumstances, you cannot recognize the same amount as revenue. Previously, there was no guidance on recognizing revenue based on the type of service and customer usage that the board established. 

So, SaaS companies continued to report revenue like the example mentioned above for a long time. This led to overvaluation, discrepancies in accounting statements, and misinterpretations of the company's true cash position and ability to fund operations.

That's where ASC 606 (IFRS 15) comes to the rescue. 

The revenue recognition framework of ASC 606

Accounting Standards Codification Topic 606 (or ASC 606) is an accounting standard issued by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) to standardize revenue recognition processes. 

‍"The new guidance affects any reporting organization that either enters into contracts with customers to transfer goods or services or enters into contracts for the transfer of nonfinancial assets unless those contracts are within the scope of other standards (for example, insurance contracts or lease contracts)." (FASB)

ASC 606 suspends all existing revenue recognition provisions under US GAAP (Generally Accepted Accounting Principles) and IFRS (International Financial Reporting Standards).

The goal of ASC 606 is to:

• Remove inconsistencies and weaknesses of existing accounting standards.
• Provide a straightforward framework for addressing revenue issues.
• Provide more valuable and accurate information to investors or other business stakeholders.
• Enable the finance team to quickly recognize and report revenue. 

ASC 606 is a game changer by introducing a consistent and simpler approach to revenue recognition. Where previously, different rules existed for different industries, ASC 606 provided a unified guideline for all industries. 

The basic concept of ASC 606 is that revenue is only recognized when goods or services are transferred to the customer in proportion to the amount that has been delivered to the customer. 

Five-step revenue recognition framework with ASC 606

The ASC 606 standard offers a five-step model that can be applied to businesses that enter into contracts to provide goods and services to customers. 

Step 1: Identify the contract(s) with customers

The first step in revenue recognition is establishing a contract between you and your customer. 

A contract can be written, verbal, or implied, but make sure that ASC 606 applies to the contract only if the following criteria are met:

• The parties to the contract have approved the contract and are committed to performing their respective obligations. 
• The business and customer clearly understand each other's rights with respect to the product/service being offered. 
• The payment terms should be made clear to both parties. 
• The contract includes commercial substance (that is, the risk, timing, or amount of the entity's future cash flows is expected to change as a result of the contract).
• The entity is entitled to collect revenue in exchange for the goods/services transferred to the customer. 

If a contract does not meet the above-mentioned criteria, the entity should reassess the criteria until they are met. 

Step 2 — Identify separate performance obligations in a contract

Before recording any revenue, it's important to ensure that both parties are clear on the distinct goods and services promised to the customer.

The term "distinct" has two criteria:

• It holds value for the customer
• It can be used independently from other services 

So, for a standard contract that provides access to a singular product, there would be one performance obligation in the contract. 

The challenge starts when there is more than one obligation. Options for additional goods/services represent separate obligations if the customer is paying an additional price for them. 

A bundle of goods/services represents a distinct performance obligation if the entity sells them separately outside of the bundle or if an item is not an input to a combined output. 

Step 3 — Determine the transaction price

The transaction price is the amount of payment an entity is entitled to after the goods/services are delivered. To determine the transaction price, the entity should consider the terms of the contract and its customary business practices. This includes considering:

• Fixed payment amount stated in the contract
• Variable payment (bonuses, penalties, refunds, rebates, discounts, etc)
• Non-cash considerations (add-on benefits)
• Determine whether the payment is made before or after the payment obligations are satisfied

Subscription-based businesses often have different pricing models with varying prices for transactions depending on the pricing tier. 

For subscription businesses, a transaction price should include the following:

• The customer pays the subscription fee on their chosen payment plan. 
• Any one-time, non-refundable setup fees are charged as activation fees. 
• The stated subscription fee should include any introductory pricing for the initial subscription period. 

Step 4 — Allocate the transaction price to separate performance obligations in the contract

Once you have determined the transaction price, you need to go through the contract and allocate the transaction price to distinct performance obligations according to the customer lifecycle. If you have a simple contract with a single performance obligation, the transaction can be easily calculated according to contract length and price. 

However, if you have multiple performance obligations, an entity should allocate a transaction price to each separate performance obligation equal to the amount to which the entity expects to be entitled for each product/service.  

For instance, let's say a customer has signed a contract for $1000 against two performance obligations (access to the content and use of the software) of equal value. Then, the entity will recognize the value of $500 against each of the obligations. 

Step 5 — Recognize revenue when (or as) the entity satisfies a performance obligation

Now comes the most exciting part—recognizing revenue. After all performance obligations are satisfied, customers get what they paid for. 

Here are some crucial factors to keep in mind:

• Revenue is recognized either over time or at the point the product/service is delivered. 
• For performance over time, revenue is recognized after measuring the progress of completion in a timeline. 
• The output method recognizes revenue according to the value transferred to the customer. 
• The input method recognizes revenue based on the efforts put into satisfying performance obligations. 

If the obligation does not meet any of the criteria for revenue recognition over time, it is satisfied after the product/service is delivered. 

Challenges SaaS companies face with ASC 606

Even though ASC 606 simplifies revenue recognition to a large extent, it also comes with a set of challenges. SaaS companies tend to encounter specific challenges as compared to issues faced by tangible goods. Let's explore how these challenges impact revenue recognition:

• One of the key challenges SaaS businesses face is understanding the terminologies used in ASC 606. They have a unique set of guidelines compared to traditional revenue recognition methods that can fry your brain. 
• The biggest challenge is determining methods of recognizing recurring subscription revenue. Under ASC 606, this revenue needs to be recognized over time as customers receive the benefits. 
• ASC 606 requires companies to determine transaction prices for each performance obligation. Due to the complexity of their offerings, this can be challenging for SaaS businesses. 
• Recognizing revenue overtime for long-term contracts is tedious. Most businesses start with a basic spreadsheet to track revenue recognition. 

Revenue recognition with Zenskar 

Zenskar is a modern subscription management solution that automates revenue recognition for SaaS businesses with custom revenue recognition rules, generates audit-ready financial reports, and automates revenue accounting end-to-end. 

These are some revenue recognition features that help SaaS businesses:

• The biggest challenge SaaS businesses face when recognizing revenue is accounting for revenue over time. Zenskar recognizes revenue using straight-line, exact days, fixed periods, milestones, usage-based, or end-of-term methods.
• Zenskar will help you create financial reports, including balance sheets, P&L statements, and revenue reports, adhering to ASC 606/IFRS 15 five-step model.
• Zenskar allows the finance team to build and modify accounting rules, revenue recognition logic, and reports without relying on engineers. 
• With Zenskar, you can adjust the reporting period and apply advanced filters to customize financial reports. Focus on the data that matters most to you.

Curious to learn more? Book a demo, and we'll show you how Zenskar can automate revenue recognition.  

Frequently asked questions (FAQs)

1. What is ASC 606, and how does it impact revenue recognition? 

Accounting Standards Codification Topic 606 (or ASC 606) is an accounting standard issued by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB) to standardize revenue recognition processes. It recognizes revenue from business contracts only after the revenue is earned. 

2. What are the five-steps for recognizing revenue according to ASC 606? 

The ASC 606 outlines a five-step revenue recognition framework that must be followed to properly recognize revenue:

Step 1 — Identify the contract(s) with customers.
Step 2 — Identify separate performance obligations in a contract.
Step 3 — Determine the transaction price.
Step 4 — Allocate the transaction price to the separate performance obligations in the contract.
Step 5 — Recognize revenue when (or as) the entity satisfies a performance obligation.

‍3. What are the benefits of the ASC 606 accounting standard? 

ASC 606 is a game changer by introducing a consistent and simpler approach to revenue recognition. Where previously, different rules existed for different industries, ASC 606 provided a unified guideline for all industries. It only recognizes revenue when goods or services are transferred to the customer in proportion to the amount that has been delivered to the customer.