Blog / InspirationWednesday, May 1, 2019

A Guide to SaaS Accounting & Revenue Recognition Methods

Fanny Josefine Fredskilde

A Guide to SaaS Accounting & Revenue Recognition Methods

While SaaS plays as increasingly prominent role in the lives of many, it is still a relatively new means of providing or using a service as a standalone niche.

As such, not only has SaaS brought about a different way of working for millions of people around the world, it’s also introduced a different way of accounting, which we call SaaS accounting, and sits alongside revenue recognition methods.

What is SaaS Accounting & Revenue Recognition?

Accounting for SaaS companies and revenue recognition are different to what might be considered traditional accounting methods that you would use when selling a product or a one-time service. Using these methods are necessary when you sell SaaS on a subscription basis so that you can carefully and accurately measure current and future revenues.

Using these methods require you to use a wide array of business metrics and prediction models to calculate your SaaS revenue. These will then help you to decide where you need to focus your business and your energy from a strategic standpoint to maximise growth opportunities.

What are we Actually Measuring?

Revenue only becomes revenue when you have provided the service that has been paid for.

Until your business has provided a service, this potential revenue is a liability. This is because the customer could cancel and ask for their cash back if you don’t deliver the service.

For example, let’s say you sign up a customer to your SaaS platform at $1,000 a year, for five years.

Even if the customer pays for each year upfront, you still have a contractual obligation to provide services for the year, and if you don’t you will potentially be liable for returning that $1,000.

With this explanation we can therefore see that we can’t account that $1,000 until after 12 months, when we have delivered the service in full.

Ways of Conducting Revenue Recognition and Measuring Sales Metrics

There are multiple ways of calculating and forecasting revenue in SaaS accounting.

Each of the ways we’re going to explore has strengths and weaknesses. Many SaaS businesses choose to use some or all of these in order to get a fuller picture of the health of their business.

Generally, SaaS accounting and revenue recognition can be split into the following categories:

  • Booking
  • Cash collection
  • Recognized revenue
  • Deferred revenue
  • Monthly/Annual Recurring Revenue (MRR/ARR)

While there are many more business metrics that you may use to measure the health of your business, these are the primary ones that will help you with SaaS accounting and revenue recognition.

Please note that while we will look at booking and cash collection, they’re not true revenue recognition models as they don’t account for whether your business has provided the service. Instead, they are sales metrics, but remain useful for this purpose.

Let’s look at the potential benefits and downsides of using these SaaS accounting rules and revenue recognition methods.

Booking

Booking is what it says. It’s when you book, or sign-up, a customer.

This means that your customer has signed a contract and have committed to paying the specified amount to use your SaaS service over the agreed period, assuming of course that you deliver the service!

Sales departments commonly use the booking metric, as it highlights their success at acquiring customers as well as the assumed revenue they have generated for the business.

For example, if we continue the example from earlier, if a customer has subscribed to use your SaaS platform for five years at $1,000 a year, your booking will account for this as one $5,000 sale.

Benefits of Using Booking

The main benefit is that it’s a great metric for estimating customer acquisition. If you know the value of the average sale from a booking perspective, this can help you to also analyse the effectiveness of your sales teams and be viewed alongside customer acquisition cost (CAC) and other related metrics.

Downsides of Using Booking

The main downside of using booking is that it doesn’t tell you whether you’ve received the revenue yet, as you have not delivered some or all the promised service yet. Depending on your business operations, your booking metric could also be providing a “false positive” in terms of the health of your business.

For example, if you have a huge booking figure, but that is spread over many months, this could translate into a challenging MRR figure in terms of making your business profitable.

Cash Collection

Cash collection is when you receive the payment from the customer. Cash collection doesn’t account for expenses or if the customer has committed to making future payments, as they would do in a subscription model.

Cash collection is a good way to get an estimate of how much money you have in your business and can use right now.

Benefits of Using Cash Collection

Cash collection gives you an accurate measurement of exactly how much money your business is acquiring at a given time.

Downsides of Using Cash Collection

Cash collection doesn’t account for “bigger picture” finances, such as contractually obliged payments, recurring revenue, or potential losses. For example, while you can count the cash you have on-hand, this remains a liability as you may end up needing to repay the customer if the services aren’t delivered.

Recognised & Deferred Revenue

Recognised revenue is the current and actual revenue you have made from a subscription.

Continuing the example from earlier, if your $1,000 a year customer gets into the fourth year of their contract, your recognised revenue is $3,000. That cash is safe, it’s “real”, guaranteed revenue, that you can use as cash flow in your business. If your customer unsubscribes or cancels you would not need to return this revenue.

On the other hand, deferred revenue is revenue that you can expect to receive as you fulfil your obligations. It isn’t guaranteed revenue, as it is dependent on you delivering the service you have said you would, but it’s revenue you can expect to receive and that your customers will be obliged to pay you.

Continuing the same example, your $1,000 a year, five-year customer with recognised revenue of $3,000 therefore has a deferred revenue figure of $2,000.

Deferred revenue (what you expect to make) + recognised revenue (what you have made) = total contract value.

Benefits of Recognised & Deferred Revenue

The benefits of using these models is that you can view the exact total contract value, split between what you have earned and what you should earn in the future, both on a per subscription basis and also in a bigger picture context for all of your subscribers.

Downsides of Recognised & Deferred Revenue

The downsides of using these metrics is that while you have a clear picture of revenue, you don’t have visibility of cross and upselling success, churn, or estimated revenue if your customer continues to subscribe after the end of an initial contract. As such, the use of these metrics can be limited if you exclusively offer monthly or annual recurring contracts.

Monthly/Annual Recurring Revenue (MRR/ARR)

MRR and ARR are two of the most commonly used SaaS metrics used to identify business health and identify areas of action.

These metrics will show you the exact revenue you can expect to make on a monthly and annual basis, factoring in churn, customers who cancel or downgrade, up and cross-selling activity, and customers buying additional features or improved services.

We have reviewed the benefits and downsides of working with both metrics in our previous comprehensive guides to MRR and ARR.

Identifying What Works for Your SaaS Business

There’s no right or wrong way to approach SaaS accounting and revenue recognition.

You need to think about and use the metrics that help you to make the best decisions for your business. It is likely that all these will have some part to play, but it’s more important for you to ensure you’re taking positive actions to help your SaaS business continue to grow.

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