You need to understand direct vs. indirect cash flow forecasting to make short and long-term business decisions. This article will show you how.
As the leader of a SaaS (software as a service) organization, providing a precise picture of your company’s financial health is critical to understand the basics of when your business can recognize revenue. Suppose you recognize the cash from your bookings as revenue in the wrong period. Your company’s financial reports will be inaccurate.
Revenue recognition is the accrual accounting principle that specifies how and when you can record your business’s sales and non-operating income as revenue. Your revenue isn’t necessarily equal to the amount in your bank account or your billing pipeline: When customers pay your business for a service that hasn’t been provided yet, this payment becomes a liability known as deferred or unearned revenue. Once you’ve provided the customer with the promised service, you can recognize the payment as revenue.
Traditional business models that sell and distribute tangible goods have a precise exchange date with customers. This date is when you’re able to recognize the amount as revenue.
Revenue recognition for SaaS companies is more complex. Since customers pay upfront for a service that continues over months or even years, businesses can only recognize the revenue as the contract progresses.
To help you understand the impact on your business, this article will explain the principles of correctly handling SaaS revenue recognition and how to apply them to common SaaS revenue types.
These five steps outline a standardized process for recognizing SaaS revenue:
These rules mandate that revenue distribution from single customer payments match how your business provides the service (your performance obligations) per the contract between your company and the customer.
If the customer receives the same service throughout the contract, you can recognize an equal amount of monthly revenue. However, if the product or level of service a customer receives varies throughout the contract, your business isn’t earning revenue at a constant rate. The proportion of the monthly revenue you recognize will also vary to reflect that inconsistency.
Track the amount of revenue recognized each month from your various customer contracts in a revenue schedule. A revenue schedule also allows adjustments to ensure you’re not over-or under-estimating your future revenue.
For example, if a customer terminates their contract, you should update the schedule to stop recognizing revenue from this contract each month.
On the other hand, if a customer upgrades a contract to a more expensive subscription plan, update the schedule with the high transaction price and, therefore, a higher recognized revenue each month.
There are multiple types of revenue in the SaaS world. Still, in general, businesses can earn three types of SaaS revenue: license or user fees, support, and projects. Each of these has different performance obligations and contract types, so your business will need to recognize the revenue you receive from them in different ways.
Sometimes, your business might generate revenue through all three types simultaneously. However, suppose a product or service is available for purchase separately or is an optional add-on. In that case, treat it as a separate accounting unit with discrete revenue recognition.
Most SaaS businesses charge a base fee to access and use their software, generally billed either on a monthly, quarterly, or annual basis. The total transaction price each customer pays may vary based on any number of factors your business chooses.
For example, a customer may pay a set rate per user but receive a discount on this rate when exceeding a certain number of users. Note any discounts or additional users that alter the total transaction price in the revenue schedule.
A customer usually receives the same level of access to the software throughout a contract, so the revenue from license fees can often be recognized in equal portions each month.
For example, a customer starts a contract with a SaaS provider in January and pays a $1,200 annual subscription to use the software. If the customer’s access to the software remains equal each month throughout their contract, then the company recognizes 1/12 of the annual fee each month totaling $100 monthly.
This is often more complex for enterprise customers with multiple users, with monthly revenue often depending on user count and pricing depending on the rate at which user count increases.
In addition to software licenses, many SaaS companies offer customers the option to subscribe to consultancy services or ongoing technical support, sometimes with usage-based pricing. If a customer signs a contract to pay for a service at an hourly rate, you can track the hours of support the customer receives in a given period. You then recognize the billable amount as revenue for this period.
Alternatively, a customer may pay a fixed monthly amount or pre-pay for a quarterly or annual subscription contract for technical support.
Some services specific to the customer—for example, setup fees, implementation services, installation, or software integration—are treated as individual projects. For each project (also known as professional services), the company prepares a statement of work that explains the deliverables the customer can expect and a timeline of company milestones. Each month, you can recognize a proportion of the total revenue that matches the proportion of the project work your company has completed for the customer.
For example, a customer pays $300 for a software installation service. The company completed this project over two months, with 70% of the work completed in the first month and 30% in the second month. The company would recognize 70% of the total fee ($210) as revenue in the first month and 30% ($90) in the second month.
To gain a clear picture of the rate at which your business earns and spends money, any expenses directly associated with generating revenue should be recognized in the same period as the generated revenue. This is known as the matching principle of accrual accounting.
For SaaS companies, this means synchronizing your recognition of the cost of goods sold (COGS) with your recognition of revenue.
Understanding the standards for SaaS revenue recognition accounting and applying them correctly to your business can be intricate and time-consuming. For most SaaS founders, hiring an accountant or experienced accounting team is the only reliable way to manage revenue recognition and keep your revenue schedule accurate, compliant, and up to date.
Any qualified accountant can provide essential revenue recognition guidance. Still, to be sure your SaaS or subscription business meets all industry-specific guidelines, it’s best to work with an accountant with software revenue recognition experience.
At Zeni, we’ve worked with software companies for years, so we understand what it takes to set up SaaS company finances to run smoothly—including proper revenue recognition and monthly recurring revenue (MRR) calculations. Zeni is a full-service bookkeeping service that can handle all your company’s bookkeeping, accounting, and CFO functions with AI-powered efficiency and human expertise.
Our team takes the hassle of maintaining your financial records off your hands and tracks all your revenue and expenses with GAAP-compliant methods built to scale. Plus, with the Zeni dashboard, you gain instant access to key metrics like your monthly revenue, OPEX, and cash flow so that you can review your financial health at a glance.
Learn more about what we offer by booking a free consultation today!