It’s been a few years since the new Accounting Standards Codification Topic 606: Revenue from Contracts with Customers (perhaps better known as simply ASC 606) revenue recognition standard took full effect for both public and nonpublic entities.
To recap, public entities had to comply with ASC 606 for annual reporting periods—including interim reporting periods in between—beginning December 15, 2017. Meanwhile, the effective date for private entities was December 15, 2018.
ASC 606 had been conceived as part of a joint effort by the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) to:
- plug inconsistencies in the financial reporting of revenue under the Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards, and
- develop a common standard that could be applied across industries, jurisdictions, and capital markets.
Developing the new guidance was a major undertaking, spanning years of consultations with stakeholders in numerous industries from technology to pharmaceutical, freight and logistics, and more. Eventually, the discussions crystallized into one core revenue recognition principle:
Businesses can recognize revenue from customer contracts in their income statements only after the revenue has been earned, which is not necessarily when the cash is received.
And certainly, such a principle caused chaos for some SaaS businesses when it was first revealed. But now that it's been in effect for a few years, let’s take a look at ASC 606’s effects on the B2B SaaS finance world—both the bad and the good:
How has ASC 606 impacted the SaaS and subscription business space?
The introduction of new ways of doing things inevitably creates friction in businesses’ established routines. And when ASC 606 compliance became mandatory, SaaS businesses faced quite a few headaches.
Potentially more difficulty with compliance
ASC 606 requires businesses to adopt the accrual basis of accounting to recognize revenue. Also known as accrual accounting, this approach involves recording revenue when it has been earned (even if the business hasn’t received the cash for it yet). For SaaS businesses, however, doing so is not that easy.
That’s because SaaS businesses collect payment from customers upfront before delivering their software as a service over a time period. As a result, they can’t recognize the revenue from the payment right away. Instead, the revenue has to be recognized incrementally until the end of the customer’s contract.
While the customer’s contract is running its course, however, the customer may upgrade its plan, downgrade, or even purchase additional plans. All these introduce added revenue recognition complexity that SaaS businesses will have to grapple with when adhering to ASC 606. And with such additional complexity comes…
Increased compliance costs
To ensure ASC 606 compliance, SaaS businesses likely had to incur costs to set up new systems and modify their processes. For instance, a SaaS business might have had to procure a piece of software that supported the ASC 606 revenue recognition requirements.
Adding to the bill, the higher costs of maintaining ASC 606 compliance may also be recurring ones—such as an increase in annual audit fees due to the complexity of SaaS transactions.
Undertaking a cost-benefit analysis, however, the digital transformation spurred on by ASC 606’s introduction could have benefited SaaS businesses in other ways.
As an example, upgrading to a powerful subscription billing system could have enabled a SaaS business to not only automate its revenue recognition, but also roll out more flexible pricing, generate detailed reports, and automate its dunning management, for enhanced growth.
How has ASC 606 improved SaaS financial accuracy and accountability?
For all the challenges it caused, ASC 606 also raised revenue recognition standards (pun not intended) in the SaaS industry by…
Facilitating greater consistency in revenue recognition
Before ASC 606, previous revenue recognition standards weren’t the most consistent on how certain revenue transactions should be recognized. As a result, businesses used their own judgment to recognize revenue appropriately.
However, with a little too much freedom in this area came room for differing revenue recognition practices and uncertainty in the accuracy of revenue reports.
For instance, two SaaS businesses may have each reported making $10 million in annual revenue for a certain year. But behind the scenes, one of them may have applied creative practices to smooth over gaps in revenue recognition rules—and inflate its revenue at the same time.
But with ASC 606, adopting such dubious accounting methods is no longer possible. The gaps in previous revenue recognition standards have been plugged, facilitating greater revenue recognition consistency among businesses.
Requiring more detailed financial disclosures
In a move that improves financial accountability, ASC 606 calls for stricter disclosure requirements than its ASC 605 predecessor. For instance, businesses now have to disclose quantitative financial information such as the:
- amount of revenue recognized,
- total contract value of performance obligations that have yet to be satisfied by the end of the reporting period, and
- disaggregation of revenue.
Assumptions made when allocating transaction prices also have to be disclosed, among other qualitative disclosure requirements.
And to ensure businesses abide by not just the letter of ASC 606’s disclosure rules but also their spirit, ASC 606 specifies the objectives for disclosure. Reviewing these objectives, subscription businesses can assess whether they have provided enough information—in terms of both quantity and quality—to sufficiently fulfill their disclosure obligations.
Empowering the making of more informed financial decisions
Increased revenue recognition consistency and more comprehensive disclosures under ASC 606 both enhance the reliability of businesses’ financial statements. In turn, financial statement users will be able to make more informed financial decisions.
Leaders reviewing their SaaS businesses’ financial reports to understand their revenue and cash flow positions can have more assurance that they are getting an accurate picture of their business’s financial health. They can then safely rely on the data to make key decisions for the business’s long-term interests.
Separately, investors will be able to better compare the financial statements of different SaaS businesses. Afterward, they can make a sound judgment call on whether to increase their shareholding in a certain business, or park their money in a different business instead.
ASC 606: advancing revenue recognition in the SaaS industry
While there was an initial scramble to understand the ASC 606 revenue recognition principle and implement it, the chaos gradually faded as SaaS businesses adapted. They hired consultants to advise on compliance. They trained their staff on ASC 606 methodology. They invested in subscription billing software that can accurately recognize revenue following ASC 606 principles in real-time.
And the costs involved in doing so weren’t incurred for naught. They paved the way for improved revenue recognition consistency, as well as greater accountability and higher confidence in SaaS financial reporting as a whole.
That said, ASC 606 still has room for improvement. Some commentators have pointed out unresolved flaws of using it to recognize SaaS revenue, for instance. How will revenue recognition standards evolve further to address such issues? Only time will tell.