SaaS Revenue Recognition
Not so long ago, most consumers purchased software on discs to load onto their own computers. They used the software for years, or at least until they needed to upgrade. Today, software-as-a-service, usually called SaaS, has become the norm. With SaaS, consumers purchase a subscription to use and run software that the vendor hosts. This subscription may also include a bundle of various services. These issues have resulted in some unique revenue recognition issues, which the U.S. Financial Accounting Standards Board (FASB) has recently addressed in December 2016.
Revenue Recognition Basics and Why it’s Important:
The accounting principle of revenue recognition determines which conditions have to be met before revenue can be recognized. Below are the main criteria for recognizing revenue across various types of revenue sources (according to the U.S. Securities and Exchange Commission):
- Collection probability. How likely are you to collect payment on the sale? If improbable or difficult to estimate, you should defer revenue recognition until there is more clarity.
- Delivery is complete. Ownership of the goods must have transferred to the buyer, as well as the risks of ownership. The buyer must also have accepted the goods.
- Persuasive evidence of an arrangement. The substance of the transaction (and not just its form) should indicate that a sale transaction has indeed taken place.
- The price can be determined.
Getting revenue recognition right is important for two main reasons:
- Proper revenue recognition is the cornerstone of accrual accounting (together with the matching principle).
- A lack of proper revenue recognition policies could allow companies to manipulate their earnings in order to make their business results appear more favorable to investors, lenders, and other stakeholders.
Revenue Recognition for SaaS Companies: Simple Subscriptions:
For simple SAAS subscriptions, consumers might pay for their subscription monthly, quarterly, or even yearly. It may be tempting for the company to consider those prepayments as revenue once received, but this would not be proper revenue recognition as delivery is not complete. In fact, any money collected before delivery of the service is actually considered a liability because the SaaS company “owes” a service to its customers.
In other words, revenue must be earned, and in the case of SaaS, it might need to be earned over a period of time. For example, after the first day of a $365-yearly subscription, only one dollar has actually been earned.
Revenue Recognition for SaaS Companies: Contracts with Bundled Products:
Since December 16, 2016, a new 5-step process for recognizing revenue is now in effect for public companies (nonpublic can adopt the standard then, or defer for another year) who use bundled contracts with customers (i.e., SaaS companies).
- Identify the contract with a customer – Can be written or oral.
- Identify the separate performance obligations in the contract — Each performance obligation is a distinct and separate service
- Determine the transaction price — How much the company expects to receive for the entire contract.
- Allocate the transaction price to the separate performance obligations in the contract — This is generally based on estimates of stand-alone selling prices for each of the performance obligations in the contract.
- Recognize revenue when (or as) the entity satisfies — Revenue is then recognized over time for each of the performance obligations.
As you can imagine, step 2 is one of the more complex steps in the process, especially as SaaS bundles become more complex and professional services (e.g. setup and implementation fees) are incorporated. The key here is to review the substance (vs. just the form) of the services and be able to provide reasonable justification for the decision made.
Next Steps for SaaS Companies:
If you’re a public company, the new standards are already in effect. For private companies, we encourage you to start preparing for the new standard now. This will not only ensure you are in compliance with GAAP from a regulatory perspective, but also increase the robustness and transparency of your financials for all stakeholders. Please don’t hesitate to reach out to your financial providers and advisors for guidance!
Useful Links on Revenue Recognition: