Learn the definition of SaaS deferred revenue, why it’s important to your accounting practices, and how to properly calculate it.
December 4, 2020
As the leader of a SaaS organization, it’s critical to understand the basics of when your business can recognize revenue. If you recognize the cash from your bookings as revenue in the wrong period, you’ll have an inaccurate picture of your company’s income, including counting income you haven’t actually earned yet.
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 billings 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. Only once you’ve provided the customer with the promised service are you able to officially earn the payment and recognize it as revenue. Revenue recognition is an important accounting practice for all companies, especially those required to report earnings to investors or other stakeholders.
For traditional business models that sell and distribute tangible goods, a clear date exists when you exchange goods for payment with a customer and are able to recognize the revenue. For SaaS or software as a service businesses, revenue recognition 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.
If your business enters into a contract with a customer (whether written, verbal, or implied) to provide goods or services, you’re required to follow ASC-606 (issued by the Financial Accounting Standards Board, or FASB) and IFRS 15 (issued by International Financial Reporting Standards, or IFRS) to adhere to generally accepted accounting principles (GAAP). These SaaS revenue recognition rules standardize the process by which revenue is recognized during the transfer of promised goods or services, based on these five steps:
These rules mandate that the revenue from a single customer payment is distributed over time in proportion to how your business provides the service (your performance obligations) and in accordance with the contract between your business and the customer.
If the customer receives the same service throughout the contract, you can recognize an equal amount of revenue each month. For example, if a customer has the same access to software for the duration of a 12-month contract, your business can recognize 1/12 of the total transaction price as revenue each month since the customer has received 1/12 of the total service. However, if the product or level of service a customer receives varies throughout the contract, your business isn’t earning the revenue at a constant rate, and the proportion of the revenue you recognize each month will also vary to reflect that inconsistency.
To keep on top of how much revenue you have earned in each period, track the amount of revenue recognized each month from your various customer contracts in a revenue schedule. This schedule also allows you to make adjustments to your allocations if those contracts are updated 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. You may also need to refund any portion of the initial transaction payment that is recorded as deferred revenue in your financial statements and hasn’t been recognized yet. On the other hand, if a customer upgrades a contract to a more expensive subscription plan, update the schedule with the increased transaction price and, therefore, a higher recognized revenue each month.
In the next section, we’ll look at how these guidelines apply to the three types of SaaS revenue for many businesses.
There are multiple types of revenue in the SaaS world, but 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. In some cases, your business might be generating revenue through all three types at the same time, but if a product or service is available for purchase separately or is an optional add-on, it must be treated as a separate unit of accounting 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. Any discounts or additional users that alter the total transaction price need to be noted in the revenue schedule to recalculate the revenue recognition for coming months.
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. In this example, if the total transaction price the customer paid remains $1,200, the SaaS company recognizes $100 as revenue each month. For enterprise customers with multiple users, this is often more complex, 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 on an hourly rate, you can track the hours of support the customer receives in a given period and recognize the billable amount as revenue for this period since the service has been delivered and the customer is contracted to pay.
Alternatively, a customer may pay a fixed monthly amount or pre-pay for a quarterly or annual subscription contract for technical support. For example, a customer signs up for a $240 quarterly subscription to a support service, in addition to a software subscription. The company would recognize a 1/3 proportion of the revenue ($80) each month.
Some services that are specific to the customer—for example, setup fees, implementation services, installation or integration of software—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 when the company will achieve key 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 completes 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.
In the above example, the company receives a total of $2,460 in payment—a $1,200 subscription fee, a $960 support fee, and a $300 installation service fee—from the customer over the course of a year, but the amount of revenue it earns and can recognize varies between months in proportion to its performance obligations.
Aligning COGS With Revenue Recognition For SaaS Companies
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 that this corresponding revenue was recognized. 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. Your company’s COGS includes all costs directly related to delivering your product or service, including the cost of software hosting services and labor costs.
Understanding the standards for SaaS revenue recognition accounting and applying them correctly to your business can be complex and time-consuming. For most SaaS founders, working with an 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 basic revenue recognition guidance, but to be sure your SaaS or subscription business is meeting all industry-specific guidelines, it’s best to work with an accountant or finance firm that has experience managing software revenue recognition.
At Zeni, we’ve been working 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 finance firm that can handle all your company’s bookkeeping, accounting, and CFO functions with a combination of 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 that are built to scale. Plus, with the Zeni dashboard, you gain instant access to key metrics like your monthly revenue, OPEX, and cash flow, so you can review your financial health at a glance.