Software-as-a-Service (SaaS) companies are one of the fastest-growing types of businesses, making critical software applications available through the cloud on a subscription basis. But while your SaaS company may have significant growth potential, the nature of your business presents accounting challenges. One of the biggest SaaS accounting complexities is proper revenue recognition.
By understanding why revenue recognition can be problematic for your SaaS business and the two best ways to address this challenge, you can ensure you’re reporting your financials accurately and staying in compliance with relevant accounting standards and tax laws.
What’s So Complex About Revenue?
Revenue recognition is all about determining how and when you will record revenue and recognize it in your financial statements. While this process can be complicated for any business—even for companies that provide a tangible product—revenue recognition is especially complex for SaaS businesses.
In a SaaS business model, no physical product ever changes hands. Instead, your company retains possession of the software, so there is no specific point at which the customer receives the product. Further complicating the issue is that most contracts are recurring, and they often bundle a variety of add-on services into the monthly or annual fee rather than billing them separately.
On top of that, the more flexibility you provide your customers in how they contract for your services, the more complicated revenue recognition can be. For example, a customer on an annual SaaS contract might have the option to cancel the service before the contract term ends, or a customer on a monthly contract might be allowed to switch to an annual arrangement at any time. Both situations can make accurate revenue recognition more difficult.
How SaaS Revenue Recognition Can Go Awry
The accounting standards for revenue recognition changed effective January 1, 2018, for non-public companies with the Financial Accounting Standards Board’s ASC 606: Revenue from Contracts with Customers. This updated standard simplifies revenue recognition and brings greater consistency to financial statements across industries. Compared to the previous standard (ASC 605), the new standard requires more detailed disclosures and more information about a company’s contractual obligations.
However, some SaaS companies may need to be aware of the new revenue recognition requirements and could inadvertently fail to follow the updated standards in their accounting. In addition, it can be challenging for startups and early-stage SaaS companies that don’t have a team of internal accountants to keep up with new standards like these and apply them correctly.
But the consequences of failing to do so can be steep. If your SaaS company doesn’t recognize revenue properly, it can create a ripple effect across your business.
• Your financial statements will not be accurate. That will make it difficult to analyze your performance, make informed decisions, meet investors’ expectations (whether during due diligence or after the transaction closes), satisfy bank covenants, and respond to Securities and Exchange Commission (SEC) findings or comments.
• You will have to restate your financials. This is especially problematic if you have a business loan that requires annual audited statements or if a potential investor requests multiple years of audited financials.
• You might face tax penalties. Revenue recognition errors will likely cause you to overstate or understate your profit, which will cause you to miscalculate your tax liability. As a result, if taxes are underpaid, you’ll be hit with costly penalties and interest.
• Other calculations will be incorrect. Improperly recognizing revenue will impact any calculation that is based on your profit numbers, such as employee profit sharing or investor payouts.
Two Ways to Get SaaS Revenue Recognition Right
One of the best ways to ensure you’re recognizing your SaaS revenue correctly is to follow a methodical process for recognizing revenue in accordance with ASC 606.
At Scrubbed, our Technical Accounting Group follows a five-step process to help SaaS businesses recognize their revenue properly per ASC 606. Our technical accounting specialists take the following steps to carefully analyze each contract on a case-by-case basis and determine how to recognize the contract revenue appropriately:
• Identify the contract with the customer
• Determine the company’s performance obligations as outlined within each contract
• Determine the transaction price from the agreement, breaking down the individual revenue streams (some may be upfront, while others will occur over time) and identifying any variable considerations, non-cash considerations, or financing components, for example
• Allocate the transaction price, assigning revenue to every performance obligation in the contract
• Recognize the revenue at the point that the company meets the contracted performance obligations or over the period the company performs the contracted obligation
Reviewing each contract individually is crucial since they may vary in ways that impact revenue recognition. For instance, some contracts bundle certain services (such as implementation, customization, support, or warranty) into the monthly or annual service fee, while others bill them as separate line items. In addition, some SaaS companies deliver their services solely through in-house staff, while some outsource certain services. Each of these scenarios presents different revenue recognition implications.
The process of analyzing each contract individually is complicated and time-consuming—and the more your business grows and the more contracts you have, the more time and effort it takes. That brings us to the second way to get revenue recognition right: Partner with an outsourced accounting firm that understands SaaS accounting, like Scrubbed!
Scrubbed provides accounting and finance services for many US-based SaaS businesses, so we understand the complexities of recognizing revenue in accordance with ASC 606. Our Technical Accounting Group works closely with clients in SaaS companies to analyze their contracts, determine how to recognize the associated revenue properly, and plot the correct revenue recognition over the contract’s life. These efforts cascade down to ensuring the company’s financial statements are accurate, which is critical for running the business effectively, meeting investor requirements, and satisfying loan covenants.
If you lead a SaaS business, you can’t afford to get revenue recognition wrong. Contact the technical accounting experts at Scrubbed to learn how we can take this burden off your hands and ensure you’re recognizing revenue correctly.