Technology & Innovation

Why is revenue recognition important and how to automate it

Discover why revenue recognition is important and how to automate it for SaaS. Read now to optimize your financial accounting & ASC 606 compliance efforts.

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Revenue recognition is a critical aspect of financial accounting that can impact a company’s deferred revenue, valuation, and investor and banker covenants.  For SaaS companies, revenue recognition can be particularly challenging due to the recurring element of their contracts, renewals, and upsells. It’s critical to get it right to ensure compliance with accounting standards and accurate financial reporting. 

In this post, we’ll explore what revenue recognition is, why it’s important, and the top challenges companies face. Additionally, with a focus on SaaS revenue recognition, we will discuss how (and why) to automate it for maximum efficiency.

What is SaaS revenue recognition?

Revenue recognition is the process of accounting for revenue in a SaaS business, recording revenue earned from the sale of products or services. Unlike traditional businesses that sell goods and services, SaaS companies typically offer a subscription-based model that can make it difficult to determine when and how to recognize revenue. It’s a process that can involve multiple steps, including identifying the contract, determining the transaction price, and allocating the revenue to the appropriate accounting periods. Additionally, SaaS revenue recognition must comply with financial accounting standards, such as ASC 606.  

Deferred revenue waterfall example

When most companies make a sale, there is more to it beyond adjusting the general ledger. For example, for SaaS companies, revenue recognition refers to the distinction between contractually obligated subscription revenue and earned revenue. A customer might buy a $2,500 subscription contract, but you can’t immediately report the total $2,500 as earned revenue. 

Instead, you have to break the contract into pieces and only record revenue as earned when you’ve met its underlying contract obligations. Revenue that’s contractually obligated to you, but which you haven’t technically earned yet, is called a deferred revenue waterfall.

Revenue recognition guidelines for SaaS companies ensure a level playing field by keeping firms from inflating their financial reporting with cash they haven’t earned. 

How to report revenue from contracts with customers

For most companies that engage in one-off transactions, Generally Accepted Accounting Principles (GAAP) is sufficient. However, subscription software companies have to follow specific guidelines when reporting on revenue, contained in legislation known as ASC 606 or IFRS 15 for non-US companies. 

ASC 606 compliance requires companies to identify detailed service or performance obligations matching every payment event in a customer’s contract. 

Doing so ensures that companies will not claim revenue for services they have not yet rendered. That keeps the financial environment fair and honest for all companies and customers. 

Failing to maintain ASC 606 compliance can result in regulatory action being taken against your software organization. And it might even carry personal legal consequences for you as a CFO.

Why is revenue recognition important?

SaaS revenue recognition is important for several reasons. 

First, it’s necessary for accurate financial reporting and compliance with accounting standards. Revenue recognition must comply with accounting accounting standards, such as ASC 606. Failure to comply with these standards can result in financial penalties, reputational damage, and legal issues. 

Second, it helps ensure that revenue is recognized in the correct accounting period, which is important for forecasting and budgeting. Accurate financial statements are critical for investors, lenders, and other stakeholders to make informed decisions. 

Third, it can impact a company’s valuation and ability to raise capital. For SaaS companies in particular, revenue recognition can be complex due to the recurring nature of revenue streams and the need to account for subscription-based pricing models. 

Lastly, it can ensure operational efficiency. Automating revenue recognition using cloud-based accounting software like Sage Intacct can help you improve operational efficiency by reducing manual processes, minimizing errors, and freeing up resources for other tasks. 

What is the first step to follow for revenue recognition?  

Revenue recognition, especially in the SaaS industry, begins with a critical first step—identifying your contracts with customers.  

1. Identify your contracts with customers 

Begin by thoroughly understanding and categorizing the various contracts your SaaS business enters into with customers.  

It’s crucial to recognize these contracts, pinpoint specific performance obligations, and determine transaction prices within these agreements. 

It provides a clear framework for recognizing revenue, ensuring you account for each transaction accurately, essential for compliance, accurate reporting, and forecasting. 

After you’ve done this, follow these further 4 steps: 

2. Understand and comply with ASC 606 

ASC 606 changes the traditional approach to revenue recognition. It requires that revenue be recognized when control of services or goods is transferred, not just upon payment receipt.  

ASC 606 asks for more detailed disclosures, offering a clearer view of your company’s revenue streams and accounting practices. 

Complying with ASC 606 ensures you’re being transparent about your financial reporting, providing stakeholders with a more accurate of your revenue streams and accounting practices. 

3. Develop a robust revenue recognition policy 

Craft a policy that details your company’s accounting practices and procedures.  

Aim to standardize contracts and facilitate the identification of performance obligations and transaction prices, essential for aligning with ASC 606 requirements. 

A robust policy also helps your people because they’ll know how to recognize revenue more uniformly and efficiently. 

4. Consider automating revenue recognition processes 

We’ve already explained how automation can significantly enhance the efficiency and accuracy of revenue recognition.  

By reducing manual errors and streamlining the accounting process, you can ensure you recognize revenue promptly and correctly. 

5. Lay a strong foundation for accurate financial reporting 

By following these steps, your SaaS business can effectively navigate the complexities of revenue recognition, ensuring compliance with accounting standards and establishing a solid basis for precise financial reporting. 

Top revenue recognition challenges

Because ASC 606 aligns companies around similar standards, organizations tend to have similar struggles with SaaS revenue recognition. Some of the top challenges companies face with revenue recognition include: 

  • Identifying the contract: SaaS companies may have complex contracts from multiple sources–including subscriptions, usage-based billing, and one-time sales–that can make it difficult to identify the performance obligations and determine the transaction price. 
  • Revenue leakage: The complexity of aligning performance obligations with billing events often results in companies failing to capture revenue. 
  • Allocating revenue: SaaS businesses may offer multiple products or services, and revenue must be allocated to each of these offerings based on their relative value. 
  • Deferred revenue: SaaS companies may have deferred revenue that must be recognized over time, which can impact financial statements and cash flows. 
  • Manual inefficiencies: As firms scale, manual workflows strain under nuanced demands of maintaining ASC 606 compliance, issued by the Financial Accounting Standards Board (FASB). Manual, inefficient workflows make it more difficult to ensure accuracy and consistency in revenue recognition across departments and business units.
  • Slow response to regulatory changes: Accounting regulations are subject to changes and updates, and being slow to respond can cost you. It behooves CFOs to understand the appropriate accounting standards and regulations to follow.

Luckily, there’s a way that finance executives can quickly solve all of these challenges and even turn SaaS revenue recognition from a chore into a profit driver. 

How to solve rev rec challenges

To address these challenges, SaaS businesses can implement several strategies, including: 

  • Developing a rev rec policy: Outline the company’s accounting practices and procedures. 
  • Standardizing contracts: Standardize contracts to make it easier to identify performance obligations and determine the transaction price. 
  • Automating revenue recognition: Automate revenue recognition to reduce errors, save time, and improve compliance with accounting standards. 
  • Implementing cloud-based software solutions: Accounting and ERP software solutions, such as Sage Intacct revenue recognition software, can help automate the revenue recognition process and improve accuracy. 

When to automate revenue recognition

How can you tell when it’s time to invest in revenue recognition automation? Revenue recognition automation gives SaaS CFOs peace of mind around ASC 606 compliance

Automation can help streamline revenue recognition processes and reduce errors, which can be beneficial for companies of all sizes. However, it’s not always necessary. You should consider automating revenue recognition when: 

  • You have a high volume of transactions or complex revenue arrangements.
  • You need to improve efficiency and accuracy in revenue recognition processes.
  • You want to reduce the risk of errors and noncompliance with accounting standards. 

Simply put, it’s never too early for software organizations to automate their SaaS revenue recognition processes. 

Relying on manual ASC 606 workflows means paying employees to do mere busy work–and doing it yourself–when everyone should instead be focused on scaling the company.

The longer that continues, the more money you leave on the table. 

By outsourcing compliance to cloud-based accounting software instead of relying on manual workflows, you can:

  • Instantly identify your SaaS revenue recognition performance obligations for a given contract.
  • Rest assured that revenue leakage will be prevented in every transaction.
  • Spend time on high-productivity tasks instead of navigating the complex landscape of ASC compliance.

Best practices for ASC 606 compliance

ASC 606 is a new revenue recognition standard that replaces the previous revenue recognition standards in the United States. It’s important for SaaS companies to understand and comply with ASC 606 to ensure accurate financial reporting and compliance with accounting standards. 

Even CFOs who are strategically minded enough to implement revenue recognition automation still need to have some best practices in their toolkit. 

Some crucial best practices for ensuring uninterrupted ASC 606 compliance (beyond revenue recognition automation) include: 

  • Maintaining real-time visibility on all your outstanding customer contracts.
  • Having automated systems in place for reliably recognizing secondary charges like support fees, setup costs, and user customization.
  • Use systems flexible enough to facilitate and recognize revenue for a range of billing scenarios. 

Let’s break down the exact requirements of ASC 606 compliance.

What is ASC 606 compliance?

ASC 606 provides a framework for revenue recognition that requires companies to recognize revenue when control of goods or services is transferred to the customer, rather than when cash is received. It also requires companies to provide more detailed disclosures about their revenue streams and accounting practices. 

Remaining compliant with the SaaS revenue recognition guidelines in ASC 606 involves following a 5-step process

1. Identify contract terms: This provides a groundwork of clarity and mutually-defined obligations from the outset of your relationship with a user.

2. Stipulate performance obligations: ASC 606 compliance dictates that revenue can only be recognized after your corresponding performance obligations are met. 

3. Determine your transaction price: The overall contract price is distinct from your service obligation costs within the broader contract.

4. Assign a transaction price to every performance obligation: This step must be handled with the utmost care to avoid revenue leakage. (Or better yet, invest in revenue recognition automation.)

5. Recognize revenue when performance obligations are met: Revenue is recognized when and as each sequential performance obligation is met.  

What steps should finance leaders take to optimize their SaaS revenue recognition and guarantee ASC 606 compliance? 

ASC 606 implementation checklist

By following best practices for ASC 606 compliance, companies can ensure they are complying with accounting standards and accurately recognizing revenue. To implement ASC 606, SaaS companies should: 

  • Assess the impact of ASC 606 on the business.
  • Identify the contracts with customers and determine the associated performance obligations and transaction price.
  • Allocate the transaction price to the appropriate accounting periods. 
  • Allocate revenue to each performance obligation based on their relative value. 
  • Recognize revenue when the performance obligations are satisfied. 
  • Disclose revenue recognition policies and provide additional information as required by ASC 606. 

Untangle the complexities of ASC 606 with revenue recognition automation

ASC 606 is complex. Yet companies who invest in cloud-based revenue recognition automation can ensure compliance and even turn ASC 606 into a source of clarity and productivity. 

To ensure compliance and accuracy, companies should develop a revenue recognition policy, address challenges, and consider automating revenue recognition processes. With automated revenue recognition processes and ASC 606 compliance, businesses can focus on their core operations and growth while ensuring accurate financial reporting and compliance with accounting standards. 

Make sure you opt for an automated accounting suite that ticks off every box on this checklist: 

  • Offers centralized contract information for every customer.
  • Gives detailed readouts on deferred revenue waterfalls for transparent reporting.
  • Automatically aligns performance obligations and billing events.
  • Provides paperless audit trails.

Sage Intacct helps B2B SaaS CFOs stay on top of revenue recognition with all this and much more. ASC 606 compliance can’t wait, it’s too vital and the price for noncompliance is too high. 
To fine-tune your organization’s relationship to ASC 606, download our ebook: Sage Intacct | ASC 606 and Subscription Businesses.