On the surface, bookkeeping might not seem that complicated. A client or customer pays you money, so you record it on your books on the date it was paid.
Right? Wrong.
Because of the Financial Accounting Standards Board’s (FASB’s) Accounting Standards Codification (ASC) 606, it’s mandated that companies use what’s called revenue recognition. This means only putting something on your books as revenue as you’ve actually earned the money.
As a result, it’s key that any founder and finance personnel at any tech company understand what revenue recognition means, particularly for software as a service (SaaS) companies.
Simplifying revenue recognition
Per the accounting principle of revenue recognition, you only record revenue on your books when you’ve actually earned that money, not when the sum is paid.
If, for example, a customer pays for a year-long subscription in February, you don’t record the full amount they paid on your books for February. Instead, you need to spread that total out over the months as the customer actually uses that subscription and, as a result, as you earn that money.
If they pay you $1,000 in February for an annual subscription, you should split that into 12 months and record 1/12 of the revenue in each month. In other words, you would record $83.33 of revenue from that customer in February, $83.33 in March, and so on — all the way until January of the following year.
As you satisfy the conditions of the contract with the customer month after month, you record that revenue. Until then, it stays on your books, but you mark it as deferred revenue.
Applying revenue recognition also benefits your tech company. Recording revenue as it’s actually earned helps to keep your books as accurate and informative as possible. It prevents you from having what would otherwise look like spikes in certain months (as customers buy longer subscriptions) and dips in other months when you’re actually consistently rendering service to that customer throughout the year.
Extra considerations for SaaS companies
If you only sold one type of subscription (e.g., an annual one), revenue recognition would be fairly easy. But for many tech companies, this doesn’t stay as simple as dividing subscription fees by 12 and distributing them across the coming year.
You also need to factor in:
- Discounts (e.g., for buying annual versus monthly subscriptions, for bundling services)
- Rebates
- Changes in pricing due to the number of users/seats
- Changes in pricing due to the number of features deployed
- Refunds
Any price concessions you offer the customer need to be accounted for on your books, as do any additional ways you bring in revenue through your contracts.
This is part of why revenue recognition can be a helpful tool. Rather than assuming you had $1,000 coming in from that client, you only bank on the monthly amount you calculated. This way, if something happens — say the customer threatens to leave and you offer a discount to keep them — you can update the monthly amounts moving forward. This keeps your books accurate and helps with reliable revenue projections.
In your effort to recognize revenue when it’s earned, don’t forget about one-time fees, either. Per revenue recognition, you should record things you charge the customer for as the service is rendered. That means recording revenue for one-offs like technical support or setup fees as that service is performed. If you implement a new feature in their system in October, for example, record that fee in October.
If, however, the customer brings you on for a lengthier undertaking — say, a three-month process to integrate with another software and then train their team on usage — recognize revenue as it’s earned. In other words, divide the total fee paid by the three months over which services are rendered and record the one-third amount on your books in each of the three months.
Compliance with ASC 606
Revenue recognition isn’t just a best practice. It’s a requirement. Any company that enters into a contract to deliver goods or services is affected by FASB ASC 606, which went into effect in phases from 2017 to 2019.
Now, five years after the final phase-in, SaaS companies are expected to comply with ASC 606 and its revenue recognition requirements. Fortunately, that regulation lays out specific steps you can take to comply.
Steps to perform compliant revenue recognition
To perform revenue recognition at your SaaS company, do the following:
- Look for contracts. Any time you enter into a contract with a customer or client, it’s a sign that you need to implement revenue recognition.
- Get clear on the contract’s performance obligation. What does your company need to do to meet the terms of the contract? In many cases, for SaaS companies, that means providing that software continually throughout the life of the contract. Because you have an obligation to have your software live and functional for the contract’s duration, you cannot consider your performance obligation met until you’ve successfully serviced that customer in any given month.
- Identify the transaction price. This is the relatively easy part. You’re just looking at how much the customer is going to pay you per the terms of your contract. That generally means the subscription fee, plus any additional amount for added seats or features minus any discounts.
- Allocate that transaction price properly. It’s time for some division. If the transaction price is representative of an annual contract, divide the total amount by 12 and allocate the revenue across the 12 months. If it’s a six-month contract, divide the transaction price by six and allocate the result to each of the six months. Until that month is completed and you’ve met your performance obligation, record it on your books as deferred revenue.
- Recognize revenue as you satisfy your performance obligation. In each month that you successfully service the client, you can turn that month’s deferred revenue into recognized revenue. In doing so, you’ll be recording it on your books as you actually earn the money.
We’ve kept all of this relatively simple. SaaS companies often have unique billing models and relationships with customers that add layers of complexity. For help complying with ASC 606 and applying revenue recognition to your bookkeeping, tap our team. We specialize in accounting for tech companies, so this is well within our wheelhouse.
