Though the latest revenue recognition standard went into effect between one and two years ago for public and private companies respectively, there are still some businesses trying to work out the kinks.
Software as a service (SaaS) and subscription businesses in particular can struggle to accurately recognize revenue, leading to faulty financial reporting that can affect valuation and decision-making.
The new U.S. Generally Accepted Accounting Principles (GAAP) guideline—known as ASC 606—requires businesses to track and identify their earned and deferred revenue. This process is complicated by subscriptions, which often collect payment before all services or products are rendered. And getting revenue recognition right as a business scales becomes tedious and even unmanageable if done manually or within legacy systems.
How can subscription businesses set themselves up for compliance success? And what can billing automation as a component of your digital transformation strategy do to streamline the whole process? Let’s take a look.
Subscriptions and SaaS: Unique business models with complex potential
Revenue recognition in the traditional sales model is straightforward: a buyer makes a one-time payment for a product, and the seller provides the product. The transaction is complete, and the payment is recognized by the seller as revenue.
Under ASC 606, recurring revenue is recognized differently. A customer may pay for a year’s worth of software access, but the seller can only recognize revenue as that access is delivered. This means after the first month of a $1,200 annual subscription, only $100 is recognized revenue. The other $1,100 is deferred revenue.
This difference is tricky, but manageable, for the simplest of subscription models. However, the reality is subscription and SaaS model businesses are rarely simple. One-time initial start-up fees, hybrid and usage based billing, and mid-term contract changes are just a few complexities that put more work on a finance team’s plate.
And that, for better or worse, is just the tip of the iceberg.
ASC 606: An active challenge for SaaS and subscription businesses
As Dave Trainer explains, ASC 606 has prompted new perspectives in SaaS.
The software industry has been particularly impacted by the new rule due to the long-term nature of many cloud software recurring revenue contracts.”
Trainer goes on to point out that the new standard shifted revenue value from what has been billed to what has been licensed or delivered. For some software companies, this resulted in an apparent increase in revenue and thus, valuation.
For others, it simply created more work. Even business models similar to SaaS—like that of telecommunications giant Verizon—were hard-pressed to meet the new standard.
“Telecom companies face significant challenges regarding the timing and allocation of their revenue due to their tendency to bundle a variety of products and services together,” Trainer explains.
A temptation many SaaS and subscription business leaders may face is to keep things simple, avoiding added complexity to ease the task of revenue recognition. However, besides the fact that there are inherent complexities with SaaS and subscriptions—such as account upgrades, downgrades, and cancellations—this approach also limits a business’s competitive flexibility.
A better option is to acknowledge potential challenges and plan to tackle them head-on.
Common revenue recognition issues in SaaS and subscription businesses
Audit, tax, and advisory service provider KPMG provides a detailed handbook about the intricacies and potential challenges of SaaS and software revenue recognition. While thorough, for many business leaders the 700-page document simply reinforces the task’s complexity.
For a broader view of often-shared hurdles, we can turn to others in the industry for insight.
Fees: mandatory, optional, and extras
Baremetrics does a great job laying out the revenue recognition model with the example of a $1,200 annual subscription. Then, it takes the scenario further: what about set-up fees, add-ons, consulting services, and other additional charges?
As the company explains, mandatory charges get lumped in with the cost of the subscription and recognized over time. A $300 set-up fee would be recognized at $25/month and added to the $100/month recognized from the subscription. Optional charges like add-ons, however, are recognized as one-time purchases. You can bank that $300 immediately.
Hybrid and/or usage-based pricing
Accounting and advisory firm Warren Averett uses a fictional SaaS remote machine monitoring platform called Dashboard to illustrate how a potentially complex usage scenario is simplified with series guidance—a concept introduced by ASC 606.
“Dashboard charges its customers $50 for every hour that the underlying machine operates and transmits data to Dashboard’s platform.…[Dashboard would] simply record revenue each day based on the customer’s actual usage for that day. For instance, if the customer uses the machine for 8 hours one day and 10 hours the next, Dashboard would simply recognize daily revenues of $400 and $500, respectively.”
This seems simple enough, but many usage-based subscriptions are part of a hybrid pricing model, paired with a one-time start-up fee or low base subscription cost. This adds complexity and the need for planning.
Wide variety of contract types
Tony Sondhi, President of financial consulting and investment advisory firm A. C. Sondhi & Associates, LLC, says the customized deals brokered by sales can complicate revenue recognition.
“My favorite, of course, is when I'm reading a contract, I discover that in the margins somebody has put, in pen or pencil, some additional piece, which could be another promise to the customer. You have to make sure you capture those…. you’ve got to start building your sense of how many nonstandard contracts you have, and how many nonstandard clauses you have within the contract.”
This especially goes for situations where a business may have licensed some customers but have others subscribing to software via the cloud.
Sondhi points out the importance of defining classes or cohorts of customers to inform how payment is collected and how revenue gets recognized among different types of accounts. This can help make revenue recognition more manageable.
Keeping up with manual revenue recognition
Emily Drahzal, Manager of Revenue Operations for open source digital experience provider Acquia, describes the nightmare of aligning sales and revenue data.
“Not all of our contracting information is captured in our sales configuration system. We use Salesforce…but there was a lot of information that we needed to get that was in our contracts, within the four corners of our contract, that was maybe not in the best format.
For example, sometimes sales representatives type in some information in an open text field. Unfortunately, that's not easily transferable to another system. You can't really get that in. You can't really analyze it either. You can't report on it.”
What’s needed here is a solution that makes those open text fields unnecessary.
Overcoming revenue recognition hurdles
These are just a few of the challenges faced by subscription and SaaS businesses today, but many have a simple solution: automation.
“I see a lot of companies move on from an accounting system they've outgrown,” says Ben Murray, The SaaS CFO. “They look for a good accounting system and then from there they look for invoicing and revenue recognition software so they can have accurate financial statements. You see this technology progression with SaaS companies as they grow. And then, with those right systems in place, you can get a lot of data to understand the health of your business, the health of your recurring revenue stream, and to make sure you're going in the right direction.”
Whether taking on the recurring revenue issues above or something else like evergreen subscriptions and mid-term account changes, agile subscription billing software can automate revenue recognition with accuracy.
Don’t let the complexities of revenue recognition hold your subscription business back. If ASC 606 has you reconsidering your processes and pricing model, it’s time to automate. A digital transformation from within may be your business’s competitive advantage and its next logical step toward long-term scalability.
Keep revenue recognition manageable, and free up your team’s time to focus on business growth with automated revenue recognition.