The Revenue Recognition Principle and How it Affects SaaS Operations
What is Meant by Revenue Recognition?
Revenue recognition, commonly referred to as “rev rec” or “revenue rec”, is an accounting principle and a process for reporting revenues by recognizing the monetary value of a transaction or contract over a period of time as the revenue is “earned.” The method of allocation and the period of time are determined by rules, guidelines, and findings from organizations such the Financial Accounting Standards Board (FASB) and the SEC.
How and when revenue is recognized is determined by rules, guidelines, and findings from organizations such the Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission (SEC). These rules and guidelines are encapsulated in the revenue recognition principle, which is consistently reviewed and updated by the FASB.
In some cases, revenue recognition is easy to understand, calculate, and document. Many companies sell products that are delivered to customers immediately, such as e-commerce companies. These companies can recognize revenue immediately.
Other companies, such as subscription-based companies like Netflix, deliver their services over a period of time and must therefore recognize revenue incrementally over the period of time the service is delivered.
Furthermore, revenue recognition becomes extremely complex for B2B companies with complex offerings, such as bundled services or support with subscriptions, non-standard functions/capabilities, or when you agree to some customer acceptance criteria (e.g.,”out clauses”).
So in practice, revenue recognition is extremely complicated for B2B SaaS companies. Therefore, standards boards and regulatory agencies have established complex rules and guidelines in order to put all of these business models under one guiding principle and rein in aggressive revenue recognition actions taken to inflate actual corporate performance of public companies.
What is The Revenue Recognition Principle?
The revenue recognition principle, per the FASB website, establishes the core idea that businesses should “recognize revenue in a manner that depicts the transfer of goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for these goods or services.”.
The revenue recognition principle is particularly relevant to SaaS companies because most SaaS companies are subscription-based in nature, meaning that they recognize revenue in a slightly different way than most companies.
Subscription-based companies have varied ways of recognizing revenue that depend on when their performance obligations have been “satisfied”. Because performance obligations can be met at different times depending on your contract structure, recognizing revenue gets confusing and messy for SaaS companies. But that’s where the revenue recognition principle comes in.
Why is The Revenue Recognition Principle Important?
The revenue recognition principle is important for a few reasons:
- It will help you craft a documented revenue policy for your business
- You must follow current FASB guidelines for revenue recognition to produce audit-ready financials
- Your investors take into account your financial metrics, such as total GAAP revenue, in addition to SaaS metrics like ARR when evaluating the health of your business
What is The New Revenue Recognition Rule?
The new revenue recognition principle is called ASC 606, and it was jointly released on May 28, 2014 by both FASB, which oversees accounting principles for private entities in the US, and IASB, or the International Accounting Standards Board, that oversees international accounting practices.
How Does ASC 606 Change Revenue Recognition?
ASC 606 sought to:
- Foster a more robust framework for addressing issues with company’s revenue as they arise
- Allow for companies across industries to compare their financial statements and information
- Require more thorough disclosure so investors and auditors can understand the rationale behind a company’s metrics.
The industries that have seen the effects of ASC 606 the most are those in the telecomm, aerospace, construction, real estate, software, and asset management spaces, as these companies have products and services that take a long time to deliver to customers and therefore would not typically recognize revenue at the moment of sale.
How to Record Revenue Recognition
What are The 5 Criteria for Revenue Recognition?
In order to abide by the revenue recognition principle, businesses usually implement this five-step process:
- Identification of the contract with a customer or client.
- Identification of the obligations and promises made in that contract.
- Determination of the price of the goods or services.
- Matching of the price to different obligations in the contract.
- The recognition of revenue when the organization responsible for reporting completes or satisfies a performance obligation.
You can read more about this five-step process in our blog here.
How to Audit Revenue Recognition
Complexities in revenue recognition arise when delivering solutions to the marketplace using term subscriptions or perpetual licenses. It is recommended that all companies with term subscriptions, private or public, understand the important concepts and adopt a process for financial reporting based on revenue recognition as early as is practical.
Here are some things that can alter the way your company recognizes its revenue, and things to keep in mind when it comes to adhering to the revenue recognition principle:
- Valuation of your company is impacted by, if not solely determined by, your historic revenue performance.
- If a customer license (via perpetual or subscription license) includes any software modification or customization, revenue recognition will be impacted.
- If you bundle professional services with your customer license (via perpetual or subscription license), revenue recognition is likely impacted.
- If you bundle support with your customer license (via perpetual or subscription license), revenue recognition can be impacted.
- Simply separating contract components (referred to as “contract elements”) doesn’t necessarily affect an “unbundling.”
- How your contract is worded can make a HUGE difference in how revenue is recognized.
- How an investor or strategic acquirer calculates your revenue may differ dramatically from how you report revenue. In the end, how they calculate revenue is the only thing that matters!
- The recognition of revenue for elements within a single contract may not match the line items in that contract. In other words, the allocation of the total revenue of a contract across the different elements within the contract may be made in a manner that is different from your contract under the concept of VSOE – Vendor Specific Objective Evidence.
- There are complex rules and guidelines that determine how revenue is to be recognized, however, there remains a dimension of subjectivity in determining how exactly your company will recognize your revenue. In the end, your auditor will have the final say.
- The more you know about revenue recognition, the better your record keeping, the more you adhere to contracts and terms that simplify revenue recognition, and the more consistency you achieve in your customer licensees, the lower the risk of a disconnect between your revenue recognition methods and results and those of a strategic investor or acquirer.
Revenue Recognition Concepts – Video Overview
Revenue recognition for SaaS and subscription businesses, Parts I and II
What is Revenue Recognition? (video transcript from top of page)
Hi, I’m Claytone. I’m one of the founders here at SAS optics. And this is ask Claytone anything video series where I answering
your most pressing questions about SaaS, financials, and metrics. Welcome back today. We’re talking about revenue recognition
or rev rec for short what’s rev rec? I’m glad you asked revenue recognition or rev rec is an accounting principle. And in your business, a process whereby you claim the revenues from the contracts you’ve sold as you’ve earned, you know, typical SaaS is this, this has done monthly over the term of the contract as the services performed. Conceptually, that seems easy enough, but rather it can get complicated for SaaS businesses because frankly, Tory agencies and standards boards, such as the financial accounting standards board also known as the FASBI have created some very thorough and important rules and guidelines for companies to follow even B2B SaaS, the revenue recognition portion of your SaaS. Accounting can get more complex still. When you do things like bundled services and support together with your subscriptions, commit to delivery of any sort of nonstandard functions or capabilities and do common things in sales negotiated deals like offer discounts on some or all of the elements of your contract. These can give rise to the need, to do carve-outs revenue, reallocations determined, implicit and explicit performance obligations, and determining standalone selling prices. Most recently, the FASBI set forth new standards for revenue recognition outlined under the ASC 606 requirements, which is also known as the first 15 internationally set to take effect in 2021, 606 is here for all of us, but depending on the way you do business, these new standards may have a minimal or major impact on you. You will need a CPA to make sure you’re compliant but software like SaaS audits can help too. It’s one of the things we do best. So contact us, and see if we can help. So there you have it beauties that’s revenue recognition or rev rec. Join us next time for another ask Claytone Anything.
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