Revenue Recognition For B2B SaaS: An Expert Guide For CFOs
Jan 13, 2022
Revenue recognition is a key financial activity of any business which sometimes translates into manual and laborious processes.
For SaaS businesses, it can be particularly challenging to know exactly when to recognize deferred revenue into properly earned revenues. That’s especially true with a subscription-based model, where a fee is paid before the service is delivered, and the revenues are deferred.
Recognizing revenue can become even more complex with the various packages, add-ons, and contract specificities your SaaS company might offer.
With accounting specifically, CFOs must be careful about when and how revenues are recognized to remain compliant with standards like ASC606.
Whether you’re considering implementing a subscription revenue model or you already have one, this guide will help you learn everything you need to know about revenue recognition - with specific examples for your B2B SaaS company.
What is SaaS revenue recognition?
First thing first: revenue recognition is the concept under which revenues are recognized by the Generally Accepted Accounting Principle (GAAP).
In cash-based accounting, the revenue would be registered when the money has arrived to the company’s bank account.
In accrual accounting the revenue is recognized under different, specific conditions: revenue is recognized when a critical event has occurred, like the sale of goods or the performance of services, and a measurable amount of money has been exchanged.
To be recognized under the GAAP, a revenue must meet a set of criteria:
Revenue must be realized (paid) or realizable (a promise to pay)
Revenue must be earned (product or service is exchanged)
Why Is Revenue Recognition Important for SaaS Companies?
While the definition of revenue recognition is simple, its application is more difficult when it comes to SaaS businesses. Indeed in a subscription business, a fee is paid before the service or the product is delivered.
What’s more, SaaS businesses have complex and ever-evolving business models, with different products, fees, and contracts. Revenue recognition accounting for cloud computing (saas) therefore becomes more complicated.
CFOs must be able to separate the grain from the chaff, in other words, they must be able to allocate each revenue in order to be able to recognize it properly in their financial statements.
Key Features of Revenue Recognition for SaaS Businesses
SaaS businesses have the particularity to earn, at least partly, deferred revenues.
When a client pays for a subscription, they pay for use of a service before it has been performed.
In accounting terms, this revenue is unearned. It will only become “earned” and be recognized only when the service has been provided.
As such, even if the money is in your bank account, you can’t recognize the revenue yet: it is deferred.
In the case of a yearly subscription, SaaS collect the money at a given time but they can only recognize a part of it each month, once the service/product has been consumed or used.
That’s why deferred revenues are a liability on balance sheet statements: since the service hasn’t been delivered yet, there is a risk that it will not be - either because the business cannot or chooses not to, or because the client decides to cancel their subscription (in the case a refund is planned in the contract).
Accounting Standards for Revenue Recognition
To make it easier to recognize revenues across countries and industries, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB)
have set up norms.
This standardization means easier reporting on financial statements, which in turn makes it easier for investors to get an accurate idea of any company’s financial health, regardless of its specificities.
Today, both ASC606 and IFRS15, issued by these boards, rely on the same rules for revenue recognition. The 5-step model is described below:
Five-Step Model for Revenue Recognition
Step 1: Identify the Contract.
Identify the contract that binds you with a specific customer. Each contract, oral or written, may have its own specificities depending on what has been agreed upon by both parties.
Step 2: Identify Performance Obligations.
Find out what both parts are contractually obliged to provide. As a business, it means what the deliverables or services are expected to be rendered. Each service or product needs to be specified individually on the contract.
Step 3: Determine the Transaction Price.
Determine a price for the whole contract.
Step 4: Allocate the Transaction Price.
Decide how much of the price agreed in the previous step is allocated to each of the services or products listed in step 2. Each performance obligation needs to have its own transaction price.
Step 5: Recognize Revenue.
When the performance obligation has been satisfied by the performing party, they can recognize their revenue. The performance obligation is met when control has been transferred by the customer who can enjoy the benefits of the service or product.
Here is a quick example: Expert Company provides access to billing software with cloud-based storage during their subscription period. They sell their subscription yearly at $10.000.
Their revenue with Happy Client is recognized as bellow:
They identify which contract binds them with Happy Client.
They identify their performance obligations: a. Providing access to their billing platform to Happy Client. b. Letting Happy Client store their data on their servers.
They determine the price at $10.000.
They allocate the transaction price. Out of the $10.000 agreed: a. $6.000 is for access to their billing platform, b. $4.000 is for storage
They recognize revenues as it is performed: a. $500 is recognized at the end of each month for access to the billing platform, b. $333 is recognized at the end of each month for cloud-based storage.
The Challenges Associated with SaaS Revenue Recognition
Even if your business mainly operates on a subscription-based model, knowing when and how to recognize revenues is straightforward, especially following the official guidance.
At Upflow for example, we offer a flat plan with no variation throughout the subscription, so it’s quite simple for us to recognize our revenues.
It gets more complicated as your offer becomes more complex. And when billed quarterly or yearly, it becomes harder to track what service was provided when and over which period.
To follow the GAAP for revenue recognition, you need to recognize the revenue of each service you provide to your clients at a specific time. Access to your platform is a single service, so is storage on your servers, set-up fees, or training, etc.
Here are the SaaS specificities you need to pay close attention to for revenue recognition:
Fees: each fee is a sub-service to which you need to apply the revenue recognition framework. undefinedundefinedundefinedundefinedundefined
Usage-based pricing: revenue can be recognized based on usage, for example, if you allow your clients to store their data on your server. How and when you determine the revenue as earned depends on the consumption of your service over time.
If you have a usage-based subscription model, you need to be able to define when consumption has happened in order to recognize your revenue at the correct time.
Varied Contract types: the contracts you write might be different depending on the terms negotiated with each of your clients. And the more you grow your customer base, the more diversity there is in your contracts - especially as a SaaS is always evolving.
The contracts written 2 years ago with some long-term clients might no longer be the same ones your new clients are now signing.
Diversity of contracts means that different revenues might be recognized at different times, which is why the first step of the revenue recognition method is to identify the contract the revenue is tied to.
SaaS have a tendency to sell services as a bundle, but that’s not relevant from an accounting standpoint. What matters for your SaaS revenue recognition is what service is provided when and over which period.
Let’s take the example of a B2B CRM platform like Salesforce. A client pays a first invoice that includes the following:
Onboarding fees (one time)
Access to the CRM for 1 year
Support fees throughout the year
Training sessions (1 session now, 1 in 6 months)
Access to an e-platform with training modules (available 6 months)
Even though the client might pay everything up front, the CRM company will have to wait until the service or access is provided for their revenues to be recognized:
Onboarding fees: now
Access to the CRM: at the end of each month over the year
Support fees: at the end of each month over the year
Training session 1: now
Training session 2: in 6 months, once done
Access to e-platform: at the end of each month over 6 months
Now imagine this multiplied by the number of clients and contracts… It is a lot!
SaaS Revenue Recognition Examples
We’ve seen it before, what makes SaaS different when it comes to revenue recognition is the fact that they are subscription-based.
More than that, most B2B SaaS offer their clients different options to choose from when subscribing. The tier model, where 3 different plans are offered depending on usage, user, or features, is quite popular.
While this makes sense from a marketing & sales point of view, there are a few case scenarios to keep in mind from an accounting standpoint:
Several things can happen when a customer cancels their subscription, depending on the length of their subscription and if a refund is issued - it all depends on your contract terms.
If a customer cancels their subscription at the end of their billing period: the revenues are recognized normally, the subscription just isn’t renewed for another period. No problem.
On the other hand, if a customer cancels their subscription in the middle of it, you will have 2 scenarios:
With refund: a pro-rata is calculated. The revenue that has been earned stays the same, but the revenue that is still deferred is issued as a credit note, and a refund is issued to the customer.
Without refund: all deferred revenue is recognized at the time of cancellation. No credit note is issued.
Let’s say a customer decides to cancel their yearly subscription of $12.000 on June 15th.
With a refund:
January to May have already been earned & recognized ($5.000)
June 1st to June 15th is earned ($500)
June 15th to December 31st are deferred revenues that have been canceled, so a credit note is issued for the amount ($6.500)
With no refund: the process is simpler because the money will not be returned and there is no risk of the service not being performed by the business. All the deferred revenue will simply be recognized on June 15th.
January to May have already been earned & recognized ($5.000)
June 1st to June 15th is earned ($500)
June 15th to December 31st which were deferred revenue is now recognized ($6.500)
Now let’s say a customer decides to upgrade their plan from Simple Plan at $12.000 yearly to Double Plan at $24.000 yearly on June 15th.
Both the amount they have paid for their previous plans and their new plans will be calculated on a pro-rata basis, with a credit note and a new invoice issued.
Put simply, their deferred revenues will be canceled and the ones from their new plans will start.
January to May have already been earned and recognized($5.000)
June 1st to June 15th is earned and recognized ($500)
A credit note is issued for the rest of the year on the Simple Plan ($6.500)
A new invoice is issued for the rest of the year on the Double Plan ($13.000), with $1. 000 deferred revenues recognized at the end of June, and then $2.000 MRR.
In the case a customer decides to downgrade their plan, the same logic applies. Let’s say they downgrade from Double Plan at $24.000 to Simple Plan at $12.000 on June 15th:
January to May have been recognized ($10.000)
June 1st to June 15th is recognized ($1.000)
Credit note issued for the rest of the year on Double Plan ($13.000)
New invoice issued for the rest of the year on Double Plan ($6.5000), with $500 deferred revenues recognized at the end of June, and then $1.000 MRR.
It’s always a case of which service(s) was/were rendered and when that matters. Then, a credit note can be issued if refunds are applicable, and a new invoice drawn.
Enabling Revenue Recognition with the Right Finance Tech Stack.
Understanding the principles and specificities for revenue recognition for SaaS is important. And yet, doing it manually can quickly turn into a nightmare.
Excel spreadsheets can only go so far, especially when you take into account the high probabilities of human-made errors and the lack of collaboration available.
What you need for your SaaS company is… a SaaS! One that helps you recognize revenues and automatize all these workflows.
Good billing software will actually do the revenue recognition for you - that’s the case of Zuora, NetSuite or Chargebee. At the end of the month, they automatically calculate the difference between your turnover and the revenue recognized, which leaves you with the amount of cash earned/available.
Always keep in mind that the right tool for you will be one that’s easily integrated into your current finance tech stack!
Key Takeaways :
In GAAP, revenue is recognized when the service is rendered.
Deferred revenue is revenue that’s not been earned yet, meaning the service hasn’t been given. It is a liability.
A subscription-based model means deferred revenues. Add to that the specificities of SaaS business (various packages, add-ons, and contracts) and you get a more complicated process.
Various bodies and regulations like the ASC606 offer a 5-step method to standardize revenue recognition across industries and countries.
In the case of cancellation with a refund, downgrade or upgrade, a pro-rata is calculated, and a corresponding credit note and new invoice are drawn.
Most billing software offers automatic revenue recognition for SaaS, a must-have for any SaaS business.