Revenue Recognition Guide for SaaS Businesses in 2023
The FASB introduced new standards for revenue recognition to make the process more standardized across industries and offer more cohesive guidelines. But that doesn’t mean it made SaaS revenue recognition easier. Learn the ins and outs of recognizing revenue from your contracts under ASC 606 accounting principles.
Up until 2020, generally accepted accounting principles (GAAP) lacked a cohesive framework for revenue recognition processes.
The Financial Accounting Standards Board (FASB) came out and said that the lack of a common framework for the various standard setters meant that “issues about recognizing revenue were often difficult to resolve and economically similar transactions sometimes yielded differing revenue recognition.”
Enter Topic 606: Revenue from Contracts. Better known as ASC 606 — the revenue recognition standard.
ASC 606 introduced a much more specific and universal framework for recognizing revenue from customer contracts. But any change to accounting standards sends shockwaves through the industry.
Here’s how to navigate the requirements of ASC 606 and build more efficiency into your revenue recognition workflows.
Table of Contents
What Is SaaS Revenue Recognition?
SaaS revenue recognition is the process of determining when revenue is earned and recognized according to the ASC 606 standard under GAAP regulations.
Prior to ASC 606, there were vague and disconnected standards for recognizing revenue from customer contracts based on the general principles of matching and recognition under GAAP. Now, ASC 606 provides a framework to “depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.”
In plain English? You recognize revenue in your financial statements according to when service obligations are met — not necessarily when bills are paid.
Challenges of SaaS Revenue Recognition Under ASC 606
Change can be painful in any context, which is the underlying reason why ASC 606 can be so challenging for accounting teams.
Certain kinds of change are welcome, like the opportunity to introduce new technologies to accounting workflows that have traditionally been tedious, manual, and time-consuming. But regulatory change brings short-term chaos to accounting processes (even if the changes are ultimately good in the long run).
Before you dive into assessing your implementation of ASC 606 processes, you should know the pitfalls that lie ahead. The following are a few critical challenges that make recognizing revenue difficult for subscription businesses under this standard.
Sprawling Spreadsheet Management
Building revenue recognition schedules in spreadsheets can quickly become unwieldy due to ASC 606 requirements. When Graham Stanton was at Peloton, he said, “a lot of our revenue recognition was based on Excel spreadsheets. And we got to a point where the big Excel spreadsheet would crash someone’s laptop half the time. They’d open it, wait 10 minutes, and either it would work or the laptop would crash.”
Your business is expecting greater access to data and more valuable insights at a faster pace than ever before. You can’t afford to sink that kind of time into the rev rec process.
In a sales-led SaaS business, ASC 606 doesn’t just mean a new process for recognizing revenue — it also introduces new requirements under ASC for capitalizing commissions for your sales team.
Before ASC 606, sales commissions were considered a direct expense, paid in full in the period where cash was exchanged. But now, because those commissions are involved in the process of obtaining a contract, you have to capitalize the expense and amortize them over a set period of time (often either the life of the contract or the expected lifetime of the customer).
Understanding the Lifecycle of a Customer Contract
One of the most important aspects of SaaS accounting is staying on top of customer contracts and proactively engaging with revenue leaders to understand them. But that aspect of the job has become even more critical under ASC 606.
Accounting leaders almost have to be revenue leaders at this point, given all the requirements around understanding customer contracts. Understanding distinct products and services that could be separate performance obligations, building revenue recognition schedules according to payment terms, and capturing all the nuances of pricing terms — all of these processes can lead to minor mistakes with major compliance consequences.
How to Stay Compliant with ASC 606
The goal of ASC 606 was to provide a more cohesive framework for companies to recognize revenue in GAAP-compliant financial reports.
But like any aspect of GAAP standards, ASC 606 provides principle-based guidance. As such, there are five seemingly simple steps to follow to stay compliant.
- Identify the contracts with a customer.
- Identify the performance obligations in the contract.
- Determine the transaction price.
- Allocate the transaction price to the performance obligations in the contract.
- Recognize revenue when (or as) the entity satisfies a performance obligation.
Simple steps with highly-complex nuances when it comes to implementation and day-to-day management. Let’s go through each step in more detail.
1. Identify the Contracts with a Customer
The first step of ASC 606 revenue recognition may be the easiest for a SaaS company. If you’ve signed a new customer, you’ve agreed to contract terms (including payment terms). Those factors cover the majority of requirements for this step.
However, as we’ve noted, the actual process of keeping up with customer contracts across your business can be challenging. Building a strong bond with revenue leaders will help you stay in the loop on contract complexities like free trials, upgrade agreements, service components, and billing terms.
2. Identify the Performance Obligations in the Contract
Depending on your business model, this step could introduce some complexity to your revenue recognition processes.
A “performance obligation” is defined as any good or service the customer can benefit from. So, for a standard SaaS contract that provides access to a singular product, there would be one performance obligation in the contract.
The challenges start when you have multiple products and services included in the contract. If there are multiple goods or services in the contract that can be identified as separate promises, you have to recognize that revenue separately.
A simple example is if your business adds set-up fees for implementation services on top of the standard SaaS product pricing. Those are two distinct performance obligations that should be handled separately in the following steps.
3. Determine the Transaction Price
In many cases, this step should be simple for a standard SaaS business. The payment terms laid out in the contract determine the transaction price, whether that’s for one performance obligation (the product) or for multiple (product, add-on services, etc.).
However, ASC 606 offers a few factors that could potentially impact the recognition of your transaction prices, including the existence of financing components, the consideration payable to the customer, and noncash considerations.
But the one that is most common in SaaS is the variable consideration. When contracts include variable pricing, you should estimate either the expected value of the contract or the most likely total. Determine which approach would best predict the accurate transaction price. This is a critical factor for any SaaS company offering usage-based billing.
4. Allocate the Transaction Price to the Performance Obligations in the Contract
Look back at Steps 2 and 3. If you have a simple contract with one performance obligation, this step should be as simple as recognizing revenue based on contract price and length.
However, if you have multiple performance obligations, there are some additional factors to keep in mind. One of the most important is whether or not you’ve offered discount incentives in the contract.
This is where the concept of a stand-alone selling price (SSP) comes into play. Chargebee does a good job of explaining how this works in their ebook on ASC 606.
They explain that SSP is the price a customer pays if an individual performance obligation were sold on its own, as determined by your historical data. Using that historical data, you might find that the four products and services you’re selling at $30k to a customer come out to $37k historically on an SSP basis. That $7k discount has to be calculated as an even allocation across all performance obligations in your contract when recognizing the revenue under ASC 606.
You can imagine how complicated this can get for mature SaaS businesses with different product lines, multiple incentive levers in the sales motion, and high transaction volumes. It’s one key reason doing this work manually is so difficult.
5. Recognize Revenue When (or as) the Entity Satisfies a Performance Obligation
All the work of Steps 1 through 4 is the foundation that allows you to recognize revenue on your financial statements here in Step 5.
The previous steps should leave you with a detailed revenue recognition schedule for when performance obligations will be satisfied over the life of a contract. Here, you recognize the revenue as earned.
There are three primary line items in your financial statements that have a role in this step:
- The deferred revenue line item on your balance sheet is a liability that represents SaaS bookings that have not yet been earned (i.e., the performance obligation is not yet satisfied even if an annual contract was paid upfront).
- The accounts receivable line item on your balance sheet is an asset where performance obligations are met but you haven’t yet billed the customer to realize the revenue. This is also called accrued revenue.
- The revenue line item on the top line of your income statement is where you record the total revenue that is fully recognized and realized in a period.
Analyze and Plan Around Revenue, Billings, and Collections with Mosaic
The goal for any accounting team shouldn’t just be to nail the fundamentals of ASC 606 SaaS revenue recognition — it should be to go beyond compliance to be a more strategic business partner.
Automating revenue recognition with a tool like SaaSOptics or Chargebee RevRec can streamline all of the complex processes we’ve discussed here to help you focus your time and effort on strategic tasks. And a tool like Mosaic integrates with your revenue recognition/billing software to take analysis and financial planning to the next level.
Integrating Mosaic and a billing tool that automates revenue recognition enables you to:
- Quickly and easily create SaaS revenue waterfall and bookings to cash waterfall models so you can forecast the cash flow impact of your billings and collections processes.
- Better understand your collections performance metrics to determine where there are opportunities to improve bottom-line growth.
- Provide visibility to stakeholders in and out of finance for all things billing. This means clearer reporting around refunds, credits, and discounts so finance and accounting teams spend less time reconciling data.
Mosaic and revenue recognition software are better together. And so are finance and accounting teams. If you want to learn how Mosaic can help you forge a stronger bond between the two sides of the finance department, request a personalized demo.
SaaS Revenue Recognition FAQs
How does ASC 606 affect SaaS companies?
ASC 606 regulates the way SaaS companies record revenue in their financial reports. It provides a 5-step framework for applying GAAP’s revenue recognition principle to collections from customer contracts.