Blog / LearnTuesday, April 7, 2020
Revenue Recognition = Total Contract Value/Billing Cycle (months) *no of months spend in contract
Revenue recognition can be a complicated term for people who have never come across it before and need to apply it to their businesses. It is a unique way to estimate the revenue of a company or an organization and it applies only to specific businesses that have repetitive payments from the same customers.
Revenue recognition is an accounting principle that helps businesses estimate their actual revenue for services or products that they will deliver in the future. For example, you may have a customer who has already paid a subscription for a year in a magazine. The transaction will be completed once you deliver all the products. At the same time, you need the money to run your business. But can you use it even if you have not finished the transaction? This is the problem that many businesses encounter: they get paid in advance for products that they have not delivered yet. If their customers decide to cancel the subscription before the delivery, it can create a problem, especially when it comes to the available business funds. The worst scenario happens when you have already used their money to cover expenses or deliver the product, leading to your company losing credibility. However, it is not possible to wait for the billing period to end to use that money as a customer may subscribe for years to your product or service.
For this reason, each business must know when it can recognize the transactions as revenue without potential risks, so they will be able to use it to cover expenses. There are different solutions for each business model. Still, in this article, we will not focus on traditional and offline businesses, and instead, we will discuss more about revenue recognition for Software and SaaS.
If you have a user buy a product with an annual package of $1200 ($100 per month), you can recognize the revenue as $100 at the end of each month.
Let's assume that they made a purchase on the first of January. At the end of January, you can add $100 to your revenue-recognized account, and the remaining $1100 goes to a liability account. At the end of February, the revenue-recognized account will become $200, and the liability account will have $1,000. At the end of December, you will have recognized $1,200. If they decide to cancel the purchase and request a refund before the end of the third month, you will keep the $200 from the recognized account and give back the $1,000 from the liability account.
When there are updates, downgrades, or add-ons, you increase or decrease the recognized revenue and the liability account for the next couple of months. Thus, if the same person buys a $50 add-on in the third month that they will use until the end of the year, the recognized revenue will become $150 at the end of that month, and you will add $450 on the liability account because there are nine months left (9 x $50). As a result, you will have $350 on the recognized revenue account and $1,350 to the liability account.
When it comes to Software and SaaS, revenue recognition can become even more complicated. Your business may have a software that works 24/7 for your customers; some of them pay a monthly subscription and others a yearly subscription, and they all expect your product to be available for them in the billing period and at all times. However, they can cancel at any moment, and in many cases, ask for a refund if they are unhappy.
Also, online businesses have expenses. They must keep updating and developing their software and spending money on marketing, because if they don’t, they risk losing market share, sales and brand recognition.
In most complicated business models, online businesses may offer consulting services, support services, set up fees, and more. So, each business must figure out the revenue and how much of their subscription money they can use right now. The bad news is that systems that work for offline companies cannot help us in SaaS. They work in a completely different way, and their complications are much more straightforward. The good news is that there is a 5-step process for SaaS revenue recognition that we will cover below.
In SaaS businesses, the agreement between the customer and the business is quite standard. The business determines the cost and time of the contract, while the customer expects a specific performance and some minimum standards to be met. The only changes in the contract include any extra features that are provided by the business. For example, the customers can buy upgrades of the same software or decide to go to a more limited and cheaper version. Also, many software and Saas businesses include add-ons that a customer can buy later. All of these changes can modify the existing contract, or the business can decide to create a new one.
The customers buy a subscription because they expect a specific value from the business. In a few words, the business must deliver the product or the service in the allocated time. That's because in a SaaS business, the main principle is to provide the service or the product while meeting expectations.
The transaction price is the total cost that the customers usually see on the sales pages they browse. Thus, the business decides the price based on the value and the cost of the product or service. The transaction price can be either fixed (easier to determine) or variable (refunds, discounts, credits).
There are many strategies for SaaS businesses in this part. They may offer a refund for long-term customers, discounts, referral systems, and more. All of these strategies help them increase sales, but they may create complexities on revenue recognition.
Your company gets a part of the transaction price or a percentage of the total billing value and allocates this part to the relative stand-alone selling price, which is the price at which one would sell a promised service separately to a customer. There are not many obligations in SaaS businesses, but one primary requirement is to provide the service consistently for the period of the billing.
This is the last step in which you can finally recognize all the payments as revenue. The process is not completed if you have not offered all of the promised services or products to the buyers. As a result, you should not expect anything more from the seller, and there is no risk for refunds as well.
Recognized revenue is a complex topic and takes time to fully understand. However, if you follow the Saas Revenue Recognition steps carefully, you can definitely apply it to your business. It is essential to know how much money you can use to cover expenses and grow your company, and this may be one of the best strategies that you can use in the long term.
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