Hey, startup founders and entrepreneurs. This guide covers the basics of ASC 606 revenue recognition, the challenges of SaaS revenue recognition, and best practices for establishing and implementing revenue recognition policies and processes for SaaS businesses.
What is the Revenue Recognition Principal in Accounting
The revenue recognition principle is a fundamental accounting principle used in accrual accounting and required by Generally Accepted Accounting Principles (GAAP), which outlines the process of recognizing revenue from the sale of goods or services. The principle states that a company should recognize revenue on its financial statements only when it finally delivers the product or service to the customer, regardless of when it receives the cash.
What is ASC 606 – Revenue Recognition
Since May 2014, the Financial Accounting Standards Board (FASB) has updated its guidance on revenue recognition (ASC 606) relating to contracts and overall revenue recognition activities. In addition, it has created a framework that includes a five-step model that businesses can use to recognize revenue properly.
Five-Step Model for Recognizing Revenue – ASC 606
FASB (ASC) 606 established the Five-Step Model for recognizing revenue, which summarizes the principles for revenue recognition across all industries.
- Identify the contract(s) with the customer: This step involves determining whether a contract exists between the company and the customer and identifying the terms of the agreement.
- Identify the performance obligations: This step involves identifying the agreement made to the customer and determining whether they are distinct and can be accounted for separately.
- Determine the price: This step involves determining the amount the company is entitled to receive from the customer to fulfill its performance obligations.
- Allocate the price to performance obligations in the contract: This step involves allocating the transaction price to the distinct performance obligations identified in step 2.
- Recognize revenue after satisfying a performance obligation: This final step involves recognizing revenue as the company fulfills its performance obligations at a specific time or over an extended period.
ASC 606 and SaaS Businesses
According to ASC 606 Revenue From Contracts With Customers, it is important to recognize revenue over the subscription or contract period. Since a SaaS company continuously provides access to its software or services, this approach requires recognizing revenue as the customer uses it rather than recognizing it all at once at the time of sale.
SaaS companies apply ASC 606 guidelines to recognize their revenue correctly, as shown in the following examples:
Subscription Revenue Recognition
SaaS companies usually have a recurring revenue model based on subscription fees. The company recognizes revenue monthly or annually, depending on the subscription term, as the customer consumes the services provided.
For example, let’s say that a SaaS company sells a monthly subscription for its cloud-based project management software at $100 per month. The customer signs up for a 12-month subscription, paying upfront for the entire year ($1,200).
Under the subscription revenue recognition principle, the SaaS company would recognize revenue over the 12-month subscription period rather than recognizing the entire $1,200 upfront.
The revenue recognition would be as follows:
- Month 1: Revenue recognized would be $100 ($100 received upfront)
- Month 2: Revenue recognized would be $100
- Month 3: Revenue recognized would be $100, and so on, until
- Month 12: Revenue recognized would be $100
At the end of the 12-month subscription, the company would have recognized the $1,200 in revenue.
Service Revenue Recognition
SaaS companies may offer consulting, training, or customer support services, and they recognize revenue for these services as they perform them.
For example, let’s say that a SaaS company provides consulting services to its customers, charged at an hourly rate of $100. A customer hires the company to provide 20 hours of consulting services for $2,000.
If the company provided 5 hours of consulting services in the first month, revenue recognized in the first month would be $500 (5 hours x $100 per hour).
If the company provided another 5 hours of consulting services in the second month, revenue recognized in the second month would be an additional $500.
The company will continue this process until it completes all 20 hours of consulting services, at which point it will have recognized a total of $2,000 as revenue.
Installation and Implementation Services of Revenue Recognition
SaaS companies may charge a fee for setting up and implementing the software for the customer. They recognize revenue as they implement the services for the customer.
For example, let’s say that a SaaS company charges its customers $5,000 for implementation services related to its cloud-based project management software. The implementation services include data migration, customization, and training.
The company completed the data migration and customization work in the first month. As a result, the company would recognize revenue of $2,500 in the first month, calculated by dividing the total implementation fee of $5,000 by the two services performed.
If the company provides the training services in the second month, it would recognize an additional $2,500 as revenue. At that point, the total revenue recognized would be $5,000.
Establishing Revenue Recognition Policies
Establishing revenue recognition policies is essential for any business that wants to ensure compliance with accounting standards and accurately report financial results. The following are critical steps to establishing revenue recognition policies:
Defining Revenue Recognition Criteria
To establish revenue recognition policies, the company must first define the criteria that it must meet to recognize revenue. This includes identifying the performance obligations in the contract, determining the transaction price, and estimating the duration of the performance obligations.
Establishing a Revenue Recognition Policy
The company must establish a revenue recognition policy once it defines the criteria for revenue recognition. This policy should outline the specific procedures for recognizing revenue, including allocating revenue to individual products or services and handling changes in subscription plans or cancellations.
Documenting Revenue Recognition Policies
Documenting revenue recognition policies is important to ensure consistent application and easy auditing. This documentation should include the criteria for revenue recognition, the revenue recognition policy, and any other relevant information.
Implementing Revenue Recognition Processes
Once revenue recognition policies have been established, it is essential to implement processes to ensure that these policies are consistently followed. The following are critical steps to implementing revenue recognition processes:
Automating Revenue Recognition Processes
Many businesses use software tools to automate revenue recognition processes. These tools can help ensure that revenue is recognized correctly and streamline the revenue recognition process.
Monitoring Revenue Recognition Policies
Monitoring revenue recognition policies to ensure they are followed correctly is essential. This can include reviewing financial reports and conducting internal audits.
Reviewing Revenue Recognition Policies
Revenue recognition policies should be reviewed periodically to remain relevant and practical. This review should include an assessment of any changes in the business, changes in accounting standards, and any issues or challenges arising in the revenue recognition process.
By understanding the revenue recognition principle, ASC 606, and the unique challenges of SaaS revenue recognition, businesses can ensure compliance with accounting standards and accurate financial reporting and avoid regulatory penalties, loss of investor confidence, and reputational damage.