Proper Revenue Recognition for Subscription Businesses
For finance operations, one of the most menial and time consuming tasks is revenue recognition. This is doubly so in subscription-based businesses where the Financial Accounting Standards Board (FASB) currently doesn’t have any specific standards for SaaS. This is changing soon though with ASC 606, which I will address later in this post.
I’m going to start by covering the most common scenarios that frequently occurs in subscription businesses, and how to properly recognize revenue for each.
SaaS revenues that are collected upfront look to SAB Topic 13.A, which states, specifically, revenue should not be recognized until delivery has occurred or services have been rendered. This means for any upfront cash that’s received for a contract, the revenue gets recognized over the duration of the service provided on a straight line basis as follows:
This recognition schedule is fairly straightforward, and for most consumer SaaS companies and self-serve B2B SaaS companies, is usually enough to satisfy the Board or any auditors.
Businesses selling to the enterprise market tend to have a much harder time recognizing revenue, mostly because Sales and Customer Success teams work on ever-evolving contracts. Let’s take a look at a few examples that might occur with their customer contracts.
Scenario 1: Customer pre-pays annual contract up front for $1200, but cancels month 6 without taking a refund for whatever reason.
In accordance with GAAP, for the first 5 months, we would recognize the normal amount of $100 every month. However, because the customer cancels at month 6, the remaining months don’t have any service being rendered. Because there is still another $600 in deferred balance, the entire amount is accelerated and recognized at the month the cancellation happens:
The previous scenario is an example of refunds. Let’s take a look at an example of crediting free service time.
Scenario 2: Customer experiences outage in service month 6 on a $1200 annual contract, and the customer success team awards 3 free months as compensation
As with the previous example, the first 6 months have had their service already rendered so we would do a normal recognition schedule for them, which is $100 per month. However, now that there are 9 remaining months left, the remaining $600 deferred is re-distributed for the 9 remaining months, or $66.67 recognized each month. Note the following:
- The 3 free months cannot be worth “$0” since it is still part of the service on the original contract
- At renewal, assuming the same contract value, because the length is back to 12 months instead of 15, the recognized value each month reverts back to $100
The previous two scenarios represent common edge cases that might happen with straightforward contracts. However, the real complexities in SaaS come with contracts that are sold as a bundle of a variety of services, otherwise known as multiple-element arrangements. This includes implementation/set up fees, professional services, education, etc. in addition to the primary platform subscription fees.
Recognizing this revenue is determined by finding the standalone value of the service and are considered separate units of accounting.
Let’s take a look at an example to illustrate how this works.
Scenario 3: Customer purchases a $1200 contract with a mandatory one-time customization implementation fee of $240 and 6 months of professional fees for an additional $600
In this scenario, the implementation fee is required in order to use the software, and is therefore not a “separate service” or unit of accounting and is recognized with the software itself. However, the professional fees are offered separately, and therefore would be recognized differently from the main contract (specifically, over 6 months here).
|Recognized Platform Fees||$120||$120||$120||$120||$120||$120||$120||$120||$120||$120||$120||$120|
|Recognized Prof. Services||$100||$100||$100||$100||$100||$100||–||–||–||–||–||–|
Complex Bundled Arrangements
When selling to Enterprises, negotiations are a very common occurrence and more often than not, the agreed upon contract ends up being an amount that does not line up to the publicly available pricing (if that even exists). To prevent businesses from exploiting this ambiguity in recognizing their revenue, the FASB requires vendors to allocate the amount for each accounting unit based on it’s relative selling price. In order to derive this selling price, they have to apply a method of revenue recognition called vendor-specific objective evidence (VSOE) which focuses on the fair market value of the item being sold.
Let’s take a look on how this works with a real world scenario:
Scenario 4: Customer evaluates a bundled contract of $1200 annual subscription platform fees, with $240 for 6 months of support services and $500 for one month of professional services. In order to close the deal, the sales rep waived the professional services fee for a total of $1440 for the whole package
The first thing to note here is if the professional services fee is “waived” in the bundled contract, it doesn’t mean in accounting it’s worth $0, especially if there is a fair market value associated to it in the VSOE. Waiving the fee is a negotiation tactic that just effectively offers a discount on the bundle. First, let’s find the correct allocation amounts.
|Accounting Unit||Selling Price (VSOE)||Relative Percentage||Allocation|
With this information, we can create the recognition schedule. Remember that the professional services is only for the first month and the support services only last 6 months
|Recognized Support Service||$30||$30||$30||$30||$30||$30||–||–||–||–||–||–|
|Recognized Platform Fees||$74||$74||$74||$74||$74||$74||$74||$74||$74||$74||$74||$74|
|Recognized Prof. Services||$370||–||–||–||–||–||–||–||–||–||–||–|
The Future of Revenue Recognition – ASC 606
Instead of having separate rules for revenue recognition for each industry, the FASB are now finalizing plans to consolidate the rules to be able to apply to any type of business to be effective in December 2017, or 2019 for private companies.
The FASB core principle of the new standard is as follows:
Recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.
This includes the following five steps to achieve this:
- Identify the contract with a customer — does not have to be written
- Identify the performance obligations (promises) in the contract
- Determine the transaction price
- Allocate the transaction price to the performance obligations in the contract
- Recognize revenue when (or as) the reporting organization satisfies a performance obligation
This is not much of a change from what we’ve discussed above, but rather a much more clear step-by-step definition of rules for revenue recognition that can be easily applied across all businesses. This can be applied to even the most complex scenarios described above.
Further reading about revenue recognition:
- Things to note with revenue recognition for gift cards
- An insight into other revenue recognition challenges
- Everything you need to know about cash accounting revenue recognition for subscription businesses
- Some more ASC 606 revenue recognition challenges
- Everything you need to know about revenue recognition for E-commerce companies