Understanding revenue recognition for subscription billing can be challenging. Rev rec processes are constantly evolving with the continued growth of SaaS companies. This has led to a scramble to establish best practices for some companies.
Despite their complexity, these less traditional billing models can be beneficial for those who want to maximize revenue and capture new markets. Understanding how to recognize revenue is critical to the success of newer billing models and feeds into every aspect of a company’s financial health.
It’s a mistake to assume that only the finance teams need to understand how it works. Most companies will need to get feedback from numerous departments, so they can evaluate contracts, strategies, key performance metrics, planning, budgeting, pricing strategies, and even IT requirements.
In this blog, you’ll learn all about revenue recognition and get access to useful resources. We will cover the complexities of “rev rec” for recurring billing, as well as, the accounting standards that you will need to meet (i.e., ASC 606 and IFRS 15).
So, what is Revenue Recognition?
It is a generally accepted accounting principle (GAAP) referring to how you recognize revenue. Regardless of when money lands in an account, the revenue only counts when the product or service is delivered and accepted. It helps companies identify what is actual revenue and what is a liability and should be deferred revenue.
In more traditional business models, the difference between cash collection and revenue recognition is often subtle, delivery of the product happens at the time of the transaction. For SaaS companies, it’s not so simple. Revenue should be recorded depending on how it accrues over time. You should only ever recognize revenue when the entire revenue-generating process is complete i.e., you must not recognize revenue until the contract’s performance obligation has been met and accepted.
Why is revenue recognition important for subscription billing?
Understanding revenue recognition feeds into every aspect of your business, and that’s having full financial visibility. Recording revenue before earning it may lead you to believe you can invest more than is available. On the other hand, failing to recognize revenue can mean you underestimate your resources and miss opportunities to invest in growth.
Similarly, if you’re looking to go public, win over investors, or secure business loans, you will need to accurately recognize and defer revenue on your financial statements. Your company will suffer if you don’t fully understand the impact of precise rev rec on your business decisions.
Revenue recognition is also crucial for corporate tax calculations and compliance. The new accounting standards ASC 606 and IFRS 15 help SaaS companies better understand how rev rec works and what they need to do to stay compliant.
Deferred revenue is key to financial health for subscription billing
You earn revenue for a service each day that you deliver that service. If you claim the unearned income, it can lead to tricky situations if customers decide to complain, cancel, or ask for refunds. Deferring revenue appropriately makes it a liability and will protect your cash flow, preventing you from investing more than you earn.
Traditionally speaking, companies didn’t need to defer much of their revenue. Goods were usually paid for and received over the counter. Buying software was as simple as purchasing a disk and then downloading the content onto your hard drive. The customer had ownership of the product and might wait for years to update the technology.
In our current world, technology is advancing at an accelerated rate. Software no longer takes years to update, and by hosting services online and selling subscriptions. SaaS companies allow customers immediate access to the latest updates and configurations.
Companies are establishing recurring billing relationships that are mutually beneficial. However, this does complicate revenue recognition for the software or subscription provider. Customers may pay for services or software in advance, but you can only recognize revenue as services are delivered. For instance, if a customer buys a yearlong subscription and pays upfront. You are obliged to defer most of that revenue (as it is a liability rather than an asset) and recognize the revenue throughout the year.
Bundles bring further complications to revenue recognition for subscription billing
SaaS companies often struggle to understand revenue recognition for services sold in bundles. Sometimes, a new customer will pay for several features at once. It’s common to have consulting services, set-up fees, customization, and support services included with the initial purchase of software.
Some of these services may be optional (e.g., consultancy services). Others might be obligatory (e.g., set-up fees). Revenue recognition is determined by whether or not these services are separate units of accounting.
An example of rev rec for separate units of accounting in a bundle:
- The software for an annual fee of $5,000
- An obligatory set-up fee of $400 for customizations and instalment
- $1,000 for consultancy services over the first three months of the purchase. This is optional and could be purchased separately.
In this instance, you should recognize the revenue of the set-up fee and annual fee over the first year of the service. Though the set-up fee is delivered early in the contract, it’s obligatory. Therefore it is part of the same unit of accounting as the subscription fee.
In contrast, the consulting service can be bought separately. It is a separate unit of accounting. Recognize the revenue over the first three months as the delivery of the consultancy services occur.
The introduction of ASC 606 and IFRS 15
The growth of subscription services led to the introduction of ASC 606 and IFRS 15 by the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB). These standards help SaaS companies better manage their revenue recognition. As a result, enabling them to stay consistently compliant. They created a five-step approach that can be applied to any subscription billing structure. It outlines how to correctly recognize revenue with any contract.
The 5-step process for revenue recognition for SaaS
- Identify the contracts with a customer.
- Identify the performance obligations in the contracts.
- Determine the transaction price.
- Allocate the transaction price to the contract’s obligations.
- Recognize revenue as you satisfy the relevant obligations.
There’s a lot to learn in each of these steps, which is why we created a booklet to help you better understand each stage and how they apply to your company. You can download it for free below. Start to recognize revenue correctly and enable your company to reach its full potential.
