There’s one thing that SaaS companies typically struggle with when working out their finances… and that’s revenue recognition.
We recently spoke with the founder of a SaaS company, and she mentioned that she had closed a record number of sales that month. This was obviously great for her bottom line, but she was worried about sustaining this increase in sales, noting that she didn’t want to “show a drop in revenue”.
Now, this is a classic SaaS revenue recognition mistake — one that we see founders of SaaS companies making, time and time again. In this article, we’ll walk you through how to recognize your revenue accurately, and discuss how SaaS revenue recognition impacts your company.
What is SaaS revenue recognition?
In a nutshell, SaaS revenue recognition refers to the process of SaaS companies recognizing the monetary value that it earns for delivering its services to a client.
For SaaS companies, though, revenue recognition tends to be somewhat complex. For instance: if you’re selling a marketing tool and a customer pays for a 6-month subscription, do you recognize the entire amount as revenue for the current month? The answer is no — the cash doesn’t go down in the books as revenue until you deliver the services that your customer has paid for.
Here, it’s important to distinguish between bookings, revenue, and billings. Revenue is what you recognize when you provide your service to your customer. Bookings is the total value of the sale when you sign with your customer and billing deals with the total amount of cash your receive from your client. So, even if your customer pays you for a 12-month subscription plan upfront, you can’t recognize the full sum as revenue right off the bat. We’ll dive deeper in the difference between Revenue, Bookings and Billings in the next article.
In case you were wondering: there are specific standards for revenue recognition, as meted out by the Financial Accounting Standards Board (FASB) and the International Accounting Standards Board (IASB). Read on to find out more!
Why does revenue recognition matter?
When you conduct proper revenue recognition, this allows you to keep tabs on your Monthly Recurring Revenue (MRR). Because MRR and MRR growth are key metrics driving the valuation of a SaaS company, it’s crucial to ensure that this figure is as accurate as possible.
On top of that, conducting proper revenue recognition gives you better insights into your profitability. If you recognize your revenue upfront, without having delivered your product or services, this will artificially inflate your numbers, and it might lead you to believe that you’re doing better than you actually are. Don’t forget that your customers can always cancel their plan or request for a refund in the subsequent months.
Last but not least, consider the implications that revenue recognition has on your tax payable as well. More specifically: if your recognized revenue is higher or lower than your actual revenue, this will result in your company posting higher or lower profits, which will in turn affect the amount of taxes you’ll have to pay.
The bottom line? There’s a major difference between cash and revenue, and it won’t do to use these two terms interchangeably.
The basics of Revenue recognition
Make this your mantra: only record revenue after you’ve completed a revenue generating process.
Let’s go with the same example we previously mentioned — say your customer pays for a 6-month subscription to your marketing tool in January, and that’s $6,000 in cash sitting in your bank account.
Now, you might book the entire $6,000 in January as booking (to record that you’ve made the sale), but you should only recognize $1,000 over each month as revenue, from January to June. In other words: when you’re recording your sales figures in January, you’d record $1,000 worth of revenue, and mark the other $5,000 that you’ve received as deferred revenue. We’ll dive deeper in the difference between billing, booking and revenue in a subsequent article.
How to recognize other sources of revenue
If you’ve got other sources of revenue such as consulting, licensing, set up costs, that’s where things get a little complicated.
The general rule of thumb here is to look at whether your additional sources of revenue is offered as a standalone service (if so, it would count as a separate revenue stream).
For instance, in the case of set up costs: assuming these are mandatory for all new customers who sign up to use your product/service, and you don’t offer these as standalone services, then you’d count them together with the rest of your revenue, and recognize them over the entire lifetime of your customer’s plan.
$6,000 subscription for tool + $600 set up costs = $6,600.
$6,600 / 6 months = $1,100 revenue recognized per month.
Now, say your customer also signs up for your consulting service, and this is something that you’re offering as a standalone item. (Ie: customers can opt to pay for your consulting service, even if they’re not using your tool). In this case, you’d recognize your consulting fees separately, instead of bundling them with your customer’s subscription fee.
Assuming your consulting sessions ran over the course of 2 months, here’s what your calculations would look like:
In January and February, you’d have a total of $1,000 + $500 = $1,500 recognized per month.
From March to June, you’d have $1,000 recognized per month.
A final word on SaaS revenue recognition
We’ve covered the basics of SaaS revenue recognition in our guide, but if your business model is more complex, you might find it difficult to identify exactly when you should recognize each additional source of revenue.
If that’s the case, consider working with Insight Matters to understand and improve your numbers. We’ll help you get your numbers in line and clarify your doubts, so that you can have an accurate understanding of your company’s financial health.