The Quick and Dirty Guide to SaaS Revenue Recognition

When we think about SaaS revenue, the one we all hear about is Monthly Recurring Revenue (or Annual Recurring Revenue if you prefer), but that is not the whole story.

First of all, when do we consider it as revenue? We can only really consider it as revenue when we have issued the invoice. So, if someone has a 30 day trial, the first invoice is only issued at the end.

Great!, so once the invoice is issued can we consider it as revenue? Well not exactly, as we have not done anything yet.

Revenue Recognition

Revenue recognition is straightforward when your revenue involves selling one-off products or services. But what does that mean if your business is subscription-based? A common mistake is to book the entire invoice amount as revenue immediately. For example, if you invoice someone for $12k for an annual subscription for the year ahead, what do you do? You can't just book this as $12k in revenue because you have to provide the service for the next 12 months before you have earned the money, so you have 12 months of hosting and support to provide.

Recognizing Revenue Over Time

This is where Revenue Recognition comes in. What this says is that you should book the $12k as a liability (i.e. that you owe the customer) and then at the end of each month you should book 1/12 as a sale and reduce the liability by the same amount, so that, at the end of the year the liability should be zero and the full $12k is allocated to sales.

This also has the benefit of smoothing out the peaks and troughs to give a more realistic figure.

For more details, I highly recommend Ben Murray's Guide to SaaS Revenue Recognition and Deferred Revenue.

Revenue Types

There are a couple of main types of revenue for a SaaS business and they are all different.

Recurring Revenue

This is the typical SaaS revenue which is generated from invoicing monthly to multi-year subscription contracts. These subscriptions are normally based on a per-user charge. A typical example of this kind of revenue is Google's G-Suite where customers pay a monthly for the services for the coming month.

That's fine if it is a monthly payment but if you pay for a service yearly, then to be accurate, recurring revenue should only be recognized on a monthly basis.

So the the features of recurring revenue are:

• Based on subscription invoices
• Revenue should only be recognized over the length of the subscription contract
• Consistency in applying revenue recognition principles is crucial for accurate financial reporting

Transactional Revenue

This is where billing is based on the resources consumed. This is becoming more common particularly for API based services. A good example of this is Amazon Web Services where you pay for storage per gigabyte or per hour for virtual servers. Other examples include Stripe where you pay a percentage per transaction amount or Mailgun where you pay per 1000 emails sent.

Typical features of transactional revenue are:

• Pricing cost structure is agreed beforehand
• Revenue is defined as unit price x transaction
• The total revenue is not known until the end of the period
• This type of revenue often requires careful monitoring and auditing to ensure accurate reporting

Professional Services Revenue

Typically professional services revenue is for non-recurring services such as software configuration, training or onboarding of customers or users.

• Normally based on fixed price contracts or percent complete
• Invoices can be instalments, performance milestones or per unit of time (ie day or hours worked)
• If invoicing happens after the milestone has been completed then this can be counted as revenue. However, sometimes an invoice is issued at the start to cover the entire project. If so, then revenue recognition should apply and the revenue should be in line with the agreed percentages.
• Sometimes professional service are billed based on hours or days worked or materials required. In this case the revenue recognition should be for work already done or materials already applied so there is no revenue recognition issue.

For more details on metrics for Professional Services check out Metrics for Consulting Services.

Third-Party Revenue

Sometimes SaaS companies resell products on behalf of other companies. This revenue could be a simple commission or could be a recurring amount as the end customer renews each year. You should:

• Should track third party recurring revenue separately from once off third party revenue.
• It is up to the third party to provide the service
• Ensure proper documentation and agreements are in place to protect your business and revenue

Other Revenue

This is really a catch all category for things that don't fall into the normal categories. For example if you run a User Conference and you charge people to attend. Each event is a once off which may or may not be repeated. Other example include accounting/revenue adjustments, sales discounts, asset sales etc. It's crucial to clearly define and categorize other revenue to maintain transparency and comply with accounting standards.

• Other revenue covers things that are not part of the usual products or services offers by the company

Revenue v Cash

So we have seen that revenue is based on the amount invoices spread over the period which the services covers, so an annual contract is spread over 12 months but of course, this is all based on the understanding that the invoice converts to Cash at some point. It is important to understand that Revenue and Cash are not the same thing. There will be bad debts so some Revenue will not convert into Cash. Also, for example with annual contracts you will have the Cash but the Revenue will only match it at the end of the period.

Probably the most important difference is that you can't spend Revenue, so remember Cash is still king.

Understanding the Difference Between Accrual and Cash Accounting

In SaaS accounting standards, it’s crucial to understand the difference between accrual and cash accounting. Accrual accounting recognizes revenue as it is earned and expenses as they are incurred, regardless of when cash is received or paid. This method aligns well with the revenue recognition principle as it allows businesses to match revenue with the expenses incurred to generate that revenue, providing a more accurate picture of financial performance.

On the other hand, cash accounting recognizes revenue and expenses only when cash is exchanged. This method is simpler and provides a clearer picture of cash flow, but it can distort the true financial performance of a SaaS business.

For SaaS businesses, especially those with subscription models, adopting accrual accounting and adhering to proper revenue recognition principles is generally recommended to ensure accurate and compliant financial reporting.

Conclusion

By understanding and properly applying SaaS revenue recognition principles, businesses can ensure accurate financial reporting, maintain compliance with accounting standards, and gain deeper insights into their financial performance. This guide provides a comprehensive overview, but it's always advisable to consult with a financial advisor or accounting professional to address the specific needs of your business.

This article was originally published by Leo Moore in March 2023. The most recent update was in October 2023.

For SaaS Metrics and Analytics, check out Subbiemetrics