Fernway DiarySM

May 26, 2022

The SaaS (Software-as-a-Service) business model holds obvious appeal for startups; instead of making a one-time sale to a customer by treating software as a product, the business offers a subscription for the use of their software in exchange for fees paid on an ongoing basis (perhaps monthly, quarterly, or annually). However, this introduces complications in the way revenue is properly recognized by the business.

SaaS revenue recognition is governed by ASC 606, a revenue recognition standard published jointly by the International Accounting Standards Board (IASB) and the Federal Accounting Standards Board (FASB) that affects all businesses entering into contracts to transfer goods and services. The core principle of this standard is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. In simpler language, revenue recognition must align with when a contracted performance obligation has been satisfied with a customer.

ASC 606 specifies 5 steps for guiding businesses in how and when to recognize revenue:

1. Identify the contract(s) with a customer.
2. Identify the performance obligations in the contract.
3. Determine the transaction price.
4. Allocate the transaction price to the performance obligations in the contract.
5. Recognize revenue when (or as) the business satisfies a performance obligation.

The application of this standard to SaaS companies requires understanding that revenue recognition—the process of converting cash from bookings into revenue and accounting for it on financial statements—occurs when product/service obligations are fulfilled, which may not correspond directly with when a payment is received.

Bookings, Billings, and Revenue

Three concepts that must be differentiated in understanding how ASC 606 applies to SaaS businesses are bookings, billings, and revenue. A booking is the value of a contract signed with a customer for a specific length of time; billings are the amounts invoiced to customers; and finally, revenue is the income earned when a company has provided the contracted service to the customer. Confusing these numbers may result in improper bookkeeping practices and an inaccurate picture of performance.

To illustrate the difference, take a simple example. Company A has contracted with a SaaS provider for annual service at $24,000, which has been paid in advance. Both the booking and the billing in this case are $24,000. However, the amount received cannot be recognized as revenue at the moment the payment is made, because the contract obligation has not been fulfilled yet. This amount should be recorded as deferred revenue (also called unearned revenue), and it is treated as a current liability on the balance sheet; should the provider fail to deliver or if the customer cancels, some or all of that amount may need to be refunded. As the year progresses, the business can recognize the revenue for each month as it successfully delivers service—in this case, $2,000 per month—until the deferred revenue is fully converted to recognized revenue.

The picture for SaaS revenue recognition can easily become more complicated, as when additional setup or support fees are added to pricing structures; when customers upgrade, downgrade, or cancel plans before a contracted service period is up; or when customization or consulting services are added. Each of these scenarios may require different considerations for revenue recognition. However, adhering to the core principle is essential for accurately calculating key metrics such as Monthly Recurring Revenue (MRR) that inform understanding of business performance and guide planning.

Accurate Accounting

Due to the complexities of complying with ASC 606, SaaS startups should prioritize putting a robust accounting system in place from the beginning. Accurate financials in compliance with Generally Accepted Accounting Principles are essential not only for informed decision-making, but also to secure venture capital funding as a startup grows. Companies should seek professional advice to ensure that their accounting practices are appropriate for their business model. Fernway Solutions offers a full range of advisory, corporate structuring, tax planning, compliance, and accounting services to provide your startup with what it needs at each stage of its growth.

For more information, please contact your US tax advisory team at youradvisor@fernwaysolutions.com or visit us at www.fernwaysolutions.com.

Disclaimer:

The above content is intended to support the marketing of professional services and should not be construed as written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular tax situation. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with, or attached to this content is not intended to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Fernway Solutions assumes no obligation to inform the reader of any such changes.