SaaS revenue recognition: a step-by-step expert’s guide

For SaaS CFOs, revenue has two equally crucial variables. First, you’re tasked with helping your company generate subscription revenue through superior strategic planning. But after that, you need to meticulously follow the revenue recognition process spelled out in ASC 606. 

In this revenue recognition guide, we’ll 1) Dive into the importance of ASC 606 in SaaS finance, 2) Discuss the role of your tech stack in avoiding revenue leakage, and 3) Walk you through the five steps of recognizing subscription SaaS revenue under ASC 606.

You work hard to generate revenue, and we’re going to show you how to keep it from leaking away.

What is revenue recognition?

Revenue recognition is the process of accurately converting bookings into revenue for accounting purposes. Proper revenue recognition ensures transparent financial reporting and compliance with GAAP.

The point of having a revenue recognition standard is to maintain a level playing field among subscription companies. If a customer pays you $1,000 for an annual SaaS subscription, your natural instinct might be to jot that full amount down as earned revenue.

However, treating a subscription sale as a one-time revenue event allows companies to inflate their profits. It gives organizations an unfair competitive edge and can mislead investors. 

ASC 606 prevents that by implementing a standardized framework for gradually recognizing revenue.

What is ASC 606?

The Accounting Standards Codification 606 (ASC 606) is a global revenue recognition standard for recurring revenue companies. 

It was drafted by the Federal Accounting Standards Board (FASB) and came into effect in May 2014, and lays out a 5-step process that finance leaders are expected to use when converting bookings into revenue.

We’ll be covering each step in more detail soon. In short, however, they encompass:

1. Contract identification
2. Clarifying performance obligations
3. Setting the transaction price
4. Allocating or itemizing the transaction price
5. Recognizing revenue as your service obligations are met

As you can imagine, applying this process across every single customer lifecycle is complex. SaaS revenue recognition has many moving pieces, and unfortunately, it’s pretty unforgiving of mistakes.

If you or someone on your team accidentally diverts from this framework, you’ll experience revenue leakage. In other words, you won’t be able to report whatever revenue falls outside the scope of ASC 606. 

Luckily, you have a strong degree of influence over those risks.

Legacy accounting methods and revenue leakage

Legacy accounting is a particularly egregious offender for leaking revenue, impacting SaaS organizations’ bottom line and financial performance.

In a manual accounting department, financial data tends to be siloed. Teams and individuals update data and then share it with the rest of the group. 

This spells disaster in terms of revenue leakage because revenue recognition calls for referencing and reconciling multiple data sources.

If you approach ASC 606 manually, some degree of leaked revenue is all but guaranteed. By contrast, cloud accounting software introduces a single source of truth, automating and centralizing revenue recognition for complete accuracy. AI also helps SaaS companies maintain clarity around deferred revenue waterfalls.

Now that you have more background on ASC 606 and SaaS revenue recognition, let’s get into the nuts and bolts. 

What does each of the five steps entail?

Step 1: Identify the contract with the customer

The first step in SaaS revenue recognition is getting the contract between you and your customer ironed out. 

What are they entitled to, and what are you entitled to in return?

ASC 606 provides a variety of contract stipulations that must be met. Some of the most important criteria are that:

• The contract has been approved by both parties, and both have signaled their intent to meet their obligations.
• The business and customer both clearly understand each other’s rights with respect to the services being offered.
• The payment terms have been made clear to both parties.
• The contract is of commercial substance–in other words, the amount, timing, or risk of your future revenue is impacted by the contract.
• There is an understood likelihood of you collecting the revenue you’re owed.

Once all those conditions are met, you might still have a lingering question. How do you factor cancellations into your revenue recognition?

Accounting for subscriber cancellations

When a customer cancels their subscription, only the non-refundable portion of that revenue is recognized. 

That remaining contract revenue is recognized as a lump sum, in contrast to the gradual recognition you’re required to observe for active customers. The reason is that you can’t list undelivered services as deferred revenue. This means that your refund policy plays an important role in your revenue recognition practices. 

If, for instance, your customers can cancel at any time with a pro-rata refund, you would treat that as a daily contract for accounting purposes.

Step 2: Identify your performance obligations

Identifying your performance obligations involves determining the goods or services promised to your customer in the contract.

You’ll need to itemize each distinct obligation promised to your customer. In this context, “distinct” has two criteria:

1. It holds some sort of value for the customer.
2. It can be transferred independently from other services.

After you’ve outlined your exact performance obligations, it’s time to set a price for each one.

Step 3: Determine the transaction price

The transaction price–called the “amount of consideration” in ASC 606–is the agreed-upon price for your services.

Section 10-32-2 of ASC 606 provides some additional guidance, stating that the transaction price does not include anything collected for third parties (such as certain sales taxes). 

It further states that companies’ transaction prices may be fixed, variable, or a combination of the two.

This last bit applies to many SaaS companies with hybrid billing models–for instance, a fixed monthly price combined with usage billing.

Other examples of variable price considerations that impact ongoing SaaS revenue recognition include:

• Refunds
• Rebates
• Discounts
• Account credits

There’s one more price-related step we need to take into account when recognizing subscription SaaS revenue.

Step 4: Allocate the transaction price

Once you’ve determined the overall transaction price, you need to go through and allocate it across the distinct services provided during the customer lifecycle. 

Here’s a very basic example. Let’s say you’re the CFO of a cybersecurity SaaS organization. Your customer’s $240 annual subscription entitles them to two monthly comprehensive system checks, one on the 14th and one on the 28th.

Assuming both security scans provided your customer with the same level of value, you would divide your monthly subscription fee ($20) by two.

So, the allocated transaction price of each security scan is $10, which would be recognized on the 14th and 28th of every month as the services were performed.

Breaking down your service prices

Properly itemizing your service costs is an important piece of maintaining clarity around your cash flows and the amount of revenue you can expect.

When itemizing costs, CFOs should consider the standalone selling price of the particular service.

In other words, ask yourself, “If we were selling just this service to customers, what would we charge for it?”

Step 5: Recognize revenue as service obligations are met

In the fifth step of revenue recognition, revenue is recognized across the contract lifecycle. 

This is an arduous and error-prone process in a manual and siloed accounting department. And no wonder, since it involves repetitively reconciling multiple data sources for every customer and contract.

If this describes your status quo, it won’t be long until revenue leakage impacts your average revenue and other important SaaS metrics.

Examples of common manual problems that impact revenue recognition include employee errors around:

• Service delivery dates
• Individual price allocations
• Incorrectly applied refunds, and many other cases

You have options, however. You don’t have to accept revenue leakage as a fact of life. 

Permanently eliminate revenue leakage

The revenue standard laid out in ASC 606 can be grueling for manual SaaS companies. For SaaS CFOs at public entities and private entities alike, cloud-based accounting automation is becoming the new standard for revenue recognition.

The cloud knocks down data silos, giving finance teams a single source of truth for maximal efficiency. And this only becomes more essential as your company grows. 

As you scale, the persistent threat of revenue leakage becomes more pronounced. Manually recognizing revenue across 20 contracts is straightforward. Doing so for 200 or 2,000…not so much.

At that point, you’re risking large chunks of leaked revenue and painful fines that can limit your available resources. Cloud-based revenue leakage eliminates the problem permanently by going to its source: risky manual processes.To learn more, check out our datasheet: Revenue Recognition (ASC 606 and IFRS 15).