SaaS Revenue Recognition Simplified
As revenue recognition in SaaS is complex, we created this simple post to guide you through how to make the process easy and simple.
It’s absolutely essential for your organization to keep precise track of revenue. SaaS revenue recognition provides you in-depth insights that enable you to understand your business’s financial performance. Improving profitability means increasing revenue, and your organization can only do that if it has a holistic view of its financial performance.
The unique challenges that the SaaS business model presents can introduce complexities into revenue recognition. In this article, you’ll learn:
- The key concepts and metrics of SaaS revenue recognition
- The challenges your SaaS company is likely to face during revenue recognition
- Different ways to recognize revenue and how to apply them.
Making SaaS Revenue Recognition Easy
Revenue recognition is a Generally Accepted Accounting Principle (GAAP) which highlights certain stipulations for the accounting of revenue in financial statements. The payment that a client makes cannot be considered revenue until the delivery of the product or service. The delivery and payments are synchronous for many businesses, such as traditional software organizations.
However, SaaS revenue recognition is more complex.
All organizations entering contracts with clients for the transfer of services and goods have to comply with the revenue recognition standard ASC 606. This standard affects SaaS companies particularly strongly. The U.S. Securities and Exchange Commission states that any revenue generation through SaaS subscription services must be categorized as non-refundable up-front fees in financial accounts.
In other words, the following steps must be carried out for revenue recognition:
- Identification of the existing contract
- Identification of individual performance obligations within the contract
- Highlighting a fixed or determinable seller’s price to the client
- Allocating transaction prices across individual performance obligations highlighted in the contract
- Recognizing revenue upon the rendering of services or delivering of products.
The challenge that arises with SaaS companies concerns the last point. Even if a SaaS provider has been paid, revenue recognition cannot occur until their services are rendered.
There are many key metrics and concepts concerning SaaS revenue recognition. These include deferred revenue, unbilled revenue, monthly recurring revenue (MRR), annual recurring revenue (ARR), lifetime value (LTV), and customer acquisition cost (CAC). Here’s a breakdown of everything you need to know about these concepts and metrics.
Key Concepts and Metrics in Revenue Recognition
A basic understanding of key concepts and metrics in revenue recognition is crucial for every SaaS provider.
Deferred and Unbilled Revenue
Deferred revenue refers to money that has already been billed but can’t be recognized as revenue due to the service not being rendered yet. This can be a liability to your organization, since the failure to deliver the service would result in a responsibility to ensure the client gets their funds back.
Unbilled revenue refers to recognized but non-billable revenue, and occurs mostly due to billing schedules. Until you bill the customer, it’s regarded as a receivable, or an asset.
Monthly Recurring Revenue (MRR)
Your organization’s MRR represents its monthly revenue expectations, and is among the most important metrics for SaaS revenue recognition. It enables your company to carry out performance tracking, productivity evaluations, sales forecasts, and budget allocation.
Mathematically, it’s your organization’s average revenue per user (ARPU) multiplied by the total number of clients for the month.
Annual Recurring Revenue (ARR)
The ARR of your SaaS business represents the total revenue it has generated over the past year through active users. Your organization’s ARR offers you insights similar to the ones that its MRR does.
Customer Lifetime Value (LTV)
A customer’s LTV indicates their worth to your business. In other words, it’s a measure of their contribution to your SaaS company’s revenue throughout their relationship with you. How LTV is measured depends on the particular organization it’s being calculated for. If a service or product requires updates and maintenance, however, the LTV would also represent these charges.
The LTV is an important indicator to track future revenue, understand fluctuations in the client’s value, retain loyal customers, and evaluate marketing strategies. You can calculate the LTV by multiplying the average revenue per user with the client’s lifetime.
Customer acquisition cost (CAC)
The CAC indicates all the resources and costs your organization expends to obtain new clients. This metric is quite comprehensive; it takes marketing and sales teams’ commissions, bonuses, and salaries into account, as well as the expenses of the sales and marketing efforts themselves.
Organizations prefer retaining a client to going after new business, since customer acquisition is vastly more expensive than client retention. However, figuring out your CAC is the first step to creating sales and marketing campaigns that work for your organization.
The mathematical calculation for customer acquisition cost is straightforward. It is simply the amount spent on sales and marketing efforts divided by the number of clients acquired. However, the CAC incorporates many variables. Using analytics and attribution software like HockeyStack allows you to calculate CAC accurately.
Key Challenges of SaaS Revenue Recognition
Many SaaS companies find it difficult to keep track of constantly changing revenue recognition regulations, especially if they offer multiple products or services to clients. In fact, most SaaS companies also offer clients discounts, bundles, concessions, and even individualized pricing. These details make revenue recognition for SaaS immensely complex. Here are some key challenges that your organization may face during SaaS revenue recognition.
Key SaaS metrics are different
A SaaS company needs an analytics and attribution software that’s especially designed for the SaaS business model. Most of these companies utilize subscription models, and it’s essential that the software you utilize for revenue recognition keeps track of key metrics such as deferred revenue and unbilled revenue.
Offering services and features as bundles
As a SaaS provider, you’ll often charge clients for extra services and support fees in addition to set-up and implementation costs. Clients are also billed if they require customization of your services and for any accompanying consultations. Bundling these costs would enable you to provide clients with a more marketable, attractive pricing model. However, according to the ASC 606 standard, these costs need to be separated for proper revenue recognition.
Data silos and the errors they introduce
Using invoices and spreadsheets to track revenue is time-consuming, finicky work involving large volumes of data. Each department has a different set of data and do not have access to the same information.
Combining these data manually or with a tool that can’t automatically extract the values that you need to keep track of will result in errors. If you have a larger client base, these errors are statistically more likely to happen. Even minor mistakes can have a vast impact on your records.
Automating data collection through a dedicated SaaS analytics software allows you to eliminate all these errors. SaaS companies especially need data unification for different departments to enable them to find out exactly which activities contribute to total revenue, and to what degree.
SaaS Revenue Recognition Methods
SaaS revenue recognition involves more moving parts than other businesses have to deal with. Here are six methods for SaaS revenue recognition.
- The accrual method
The organization initially labels pre-payments from clients as prepaid assets. When the service has been rendered or the product delivered, these prepaid assets are classified as expenses.
- The appreciation method
If a SaaS company sells a product or service at an appreciated value, the appreciation method enables SaaS companies to reduce the recognized gains.
- The sales-basis method
Companies recognize revenue during the sale being made, either in terms of accounts receivable (credit) or cash. However, until the product delivery or service rendering is complete, the company needs to hold off on recognizing revenue, even if they’ve obtained the money.
For instance, if a game streaming service costs $24 per year for a customer, the company’s monthly revenue for a single active customer will be $2. Now, if the company gets shut down in the middle of the year, it will have to return the appropriate amount of money to the customer for the products that haven’t been delivered.
- The percentage-of-completion method
Some companies’ services may take years to be completely delivered. However, in the course of this long time, they’re still required to prove their profitability in the form of revenue generation to stakeholders.
To utilize the percentage-of-completion method, there must be a legally enforceable, long-term contract. You’ll also have to produce the means to evaluate how complete the project is at any given time in terms of percentage. This method measures completion in terms of project milestones or incurred costs.
- The completed contract method
Companies that adopt this method recognize revenue upon contract fulfillment. The completed contract method is ideal for short-term projects since it recognizes revenue in the appropriate accounting period.
Long-term projects can also rely on the completed contract method for revenue recognition if there aren’t definite indicators of progress that the percentage-of-completion method is dependent on.
- Proportional performance
If the delivery of a certain service comprises more than one step, the company offering it can recognize revenue on the basis of the step’s proportional performance relative to all the other steps when the contract ends.
SaaS Revenue Recognition Scenarios
SaaS revenue recognition differs vastly for particular scenarios. Here are some common challenges that your SaaS company may face in the course of revenue recognition:
Scenario 1: A client that churns during the financial year
It’s easy to recognize revenue if you offer your clients an annual subscription for your SaaS product. However, many SaaS organizations offer their clients a level of flexibility. If your client cancels their yearly subscription in the middle, you’d have to issue a credit note or refund, or categorize the revenue you’ve received as deferred, thereby complicating the process of revenue recognition.
Scenario 2: Client switching monthly subscriptions to annual
If your clients pay monthly for your SaaS, your organization will recognize revenue monthly and use it to calculate future revenue. However, clients switching their monthly subscriptions with annual ones, say in the middle of a tax year, will result in the accounting process being derailed. You will have to calculate the service duration in days and then compute deferred revenue.
Scenario 3: Revenue recognition for subscription models
Suppose there’s an antivirus company that charges users $12 per month for their services. If a client wants to learn more about data protection and internet safety, the company charges them a further fee amounting $30.
After the initial sign-up process is complete, the service provider can recognize the $30 learner’s fee. However, they can only charge the user monthly for the recurring payments, so the first $12 will be recognized at the end of the first month. If a client pays once for the whole year, the remaining $132 is recorded as deferred revenue.
Streamline SaaS Revenue Recognition with HockeyStack
Although SaaS revenue recognition is famously tricky, utilizing an analytics software can help you out with the process. HockeyStack’s features make it ideal for any SaaS company. Here’s how.
Unified data
HockeyStack unifies all data across departments, making sure that each team in your company has access to the same information. This breaking of departmental silos erases inconsistencies in data and promotes cross-functional collaboration thereby ensuring that all your revenue information is free of errors. It simplifies revenue intelligence for you while being entirely code-free.
One dashboard for all your metrics
A common challenge for SaaS companies is highlighting all the metrics that contribute to revenue recognition. Using analytics and attribution software enables you to visualize all these metrics on a single dashboard. With HockeyStack’s dashboards, you can easily keep track of all the key metrics involved in revenue recognition. It’s entirely automated, so there’s no need for guesswork.
Conclusion
SaaS companies have specific needs for revenue recognition so they can meet industry standards. It’s imperative that your SaaS business understands how to recognize revenue to track profitability. Unifying data across departments and using analytics tools can help you make this process more effective and efficient.
If you want to see how HockeyStack can help you track key SaaS revenue recognition metrics, try out the live demo.
FAQs:
What are the revenue models for SaaS?
The SaaS revenue model shares similarities with the recurring revenue model. SaaS companies charge their users on an interval basis, and emphasize customer retention to ensure profitability.
What are the 5 steps in the revenue recognition process?
The 5 steps as outlined by the ASC 606 standard are:
- Identification of the existing contract
- Identification of individual performance obligations within the contract
- Highlighting a fixed or determinable seller’s price to the client
- Allocating transaction prices across individual performance obligations highlighted in the contract
- Recognizing revenue upon the rendering of services or delivering of products.
