Most SaaS businesses tend to focus on their products, features, and marketing, so tackling finances comes last on their priority list.
Financial terms can also be somewhat confusing, especially recognized revenue. However, this isn’t something you should ignore just because it might be a bit complicated.
When you’re not aware of the pitfalls that come with not recognizing your revenue, you can ruin your chances of growth or even put a lock on your business.
We’ll go over some of the most common challenges in SaaS revenue recognition that you should get familiar with in order to solve any future roadblocks efficiently.
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What is Recognized Revenue?
Five Stages of SaaS Recognized Revenue
Common Challenges in SaaS Revenue Recognition
Solution to Common Challenges
What is Recognized Revenue?
Recognized revenue is the amount of money you get in your bank account from your customers, which you only count as income once you’ve provided a service.
In ordinary monetary transactions, you’d deliver the product immediately after your customer gave you money.
For example, imagine you’re at a store, and you want a new TV. You’d go to the register, and they’d tell you how much money you owe for that new TV.
Then, you’d pay them and leave the store with your new TV.
The store gives you the product, and you give them the money. The transaction is immediately completed.
With SaaS, however, it’s a little different because it’s a subscription-based business model.
You sometimes provide the service throughout the subscription plan your customer agreed to pay, even after they have paid you.
Let’s say your customer paid upfront for a $500 annual plan.
Unfortunately, at that point, you can’t recognize that amount as revenue because you didn’t deliver the service for the agreed time.
Only after the 12 months are up, you can say you’ve earned $500 from that customer.
In SaaS, you don’t really own the products, but simply host the software and give your customer access, which can be tricky when it comes to finances and accounting.
Most SaaS companies use accrual accounting for their business and follow the generally accepted accounting principles (GAAP) for it.
Understanding the principles of recognized revenue will help you have an accurate overview of the overall state of your business.
Five Stages of SaaS Recognized Revenue
To fall under GAAP guidelines, SaaS companies need to follow five stages of revenue recognition.
If you have to provide financial statements to the IRS or your investors, you should follow this 5 step model.
It simplifies the process of recognizing revenue.
- Outline a contract with a customer: both parties have to agree to the terms and conditions outlined in the contract.
- Identify your obligations: a detailed description of all performance requirements and deliverables you need to provide to the customer should be in the contract. If there are multiple services or products, they need separate contracts.
- Agree on the transaction price: pricing should be determined based on specific criteria.
- Allocate the transaction price: every separate product or service needs to have a fixed price and stand-alone value attached.
- Recognize revenue: only after the customer benefited from your service can you recognize revenue.
Following this simple framework helps you cover all the bases for revenue recognition and legally protects you from accidental financial mishaps.
Common Challenges in SaaS Revenue Recognition
In an ideal world, accounting for SaaS would be simple, as long as you follow the prescribed GAAP model.
However, due to the specific requirements of the SaaS business model, such businesses face many challenges in revenue recognition.
Here are the most common issues that can occur.
Subscription Plan Flexibility
Flexibility in the SaaS subscription model can negatively impact revenue recognition.
Everything is fine as long as your customers stick to your annual or monthly subscription plan.
But what if they change their minds midway through the contract?
What if they downgrade, upgrade, or suddenly even cancel their subscription?
If that happens, you still can’t count your revenue before you’ve provided the service.
How you manage recognized revenue, deferred revenue, and refunds depends on the contract you made with the customer.
If refunds and cancellation fees were outlined in the contract, you can recognize the revenue from the last month before the cancellation.
For example, if a customer with a $600 annual plan upgrades to a $1200 annual plan at the end of May, you recognize revenue of $250 (5x$50) from January to May.
After that, you can record monthly recognized revenue of $100 per month for the new plan.
When changes happen, you have to make new invoices and track new metrics for the new plan.
You have to acknowledge that changes were made for an individual customer’s plan and make a note of it in your financial reporting.
Plan flexibility is manageable if you have a small customer base, but it can become a problem once your customer base grows to thousands of users.
A Wide Variety of Contract Types Due to Customization
Along with multi-tiered pricing plans, SaaS companies sometimes offer custom contracts with special offers, adding to the variety of contract types.
For example, a company may license some users for a service or product, and offer the same thing to another customer via cloud subscription.
For each of those tailor-made contracts, you need to follow GAAP’s five stages to adhere to necessary regulations.
This means having a customized contract for each particular business relationship.
To manage this complexity, segment your customer base for easier financial tracking and reporting. This will make it easier to send invoices and manage revenue recognition.
Overall, non-standard plans and contracts need a specialized approach to be recognized as revenue.
Accountants have an enormous responsibility. They have to analyze different contracts, apply rules, record recognized revenue, and track balance sheets.
They also need to be up to date with new laws and regulations to keep business within the legal framework.
With that amount of work, human error is always possible.
It is a delicate field, and balancing all of these elements can be tricky in the long run.
Using spreadsheets has been a standard for a long time, even in the age of technology and automation, but it is not the most accurate, nor the most efficient solution.
Many SaaS companies grow fast and depend on speed and accuracy. As they grow, they invest in automated billing and accounting systems to reduce costs and eliminate errors.
Even though most automated solutions have a good system for recognized revenue tracking, they still require manual surveillance and input for non-standardized contracts and other modifications.
However, overall, automated solutions save your accountant’s time and eliminate the most basic problems for the company’s accurate financial reporting.
Payment failures are one of the most common problems for SaaS revenue recognition.
They usually aren’t the customer’s fault—for instance, if they don’t realize their credit cards expire.
The more pressing problem is when they don’t have enough funds to pay for their subscription plans.
There are two scenarios of what to do when customers can’t pay for your service.
First is the partial write-off.
This happens when you can collect only a partial amount of what you’re owed, and the rest is uncollectible.
For example, your recognized revenue for a customer with a $600 annual plan is $50 per month.
However, if a customer stops paying you in August, you’ll only be able to recognize revenue from January to July, which is a total of $350.
A full write-off is another scenario.
This is probably the worst thing that can happen to a company because customers agree to a subscription plan and don’t pay for it. The entire amount is deemed uncollectible.
If a $600 annual plan doesn’t pay as was agreed due to insufficient funds, then you don’t get anything.
Payment failures are common problems, so you should be prepared for every eventuality.
Added Features and Services
SaaS often has additional features and services that users can opt for, affecting recognized revenue.
Offers in SaaS contracts often include support, service, and implementation fees on top of the initial subscription plans.
To appear more competitive and attractive, you might want to gather these services and fees at a single discounted price.
However, then you risk running into the problem of not complying with the GAAP’s guidelines.
You have to price each service separately, outline its specifics, and charge it as a separate element.
If you have additional services, charge your customers accordingly, but follow GAAP’s revenue recognition model.
Multiple products require different contracts.
Like with added fees and services, all your different products and pricing models attached to them need a separate contract.
In time, you will have standardized protocols for different contracts, but you should start with a clear sign-off process that’s managed by the finance team.
This will later help you with customer categorization.
What happens if a customer wants to make an additional purchase? How to know if your product is a separate or an added entity?
There are two criteria a product or service needs to meet to be counted as a separate product.
- The customer can benefit from it on its own or by using available resources
- The offering can be separated from others in the contract
The first one is related to the product itself, while the other is related to the context of the contract.
If your product meets the outlined requirements above, then you need to treat it separately in your books.
Usage-based SaaS subscription models require a different approach in revenue recognition.
Under GAAP, usage-based pricing and revenue are an exception.
Companies can only recognize revenue once the sale happens—and SaaS can only recognize revenue based on the customer’s use during a reported period.
But what if your user doesn’t use your service for a time?
The company is obligated to recognize revenue once the service has been consumed.
Also, the transaction price isn’t fixed as per GAAP guidelines, as the usage-based model requires pricing changes based on usage.
It’s up to your finance team to set up a variable consideration that will estimate the elements of your obligation to the customer.
A reliable pricing system can only be put in place when different departments collaborate closely. Otherwise, your finances can suffer from a lack of accurate reporting.
You should consider user-based pricing only if you know that you’ll be able to follow GAAP guidelines and benefit in the long-term financially.
Read more: How SaaS Companies Make Money?
Solution to Common Challenges in Revenue Recognition
Automating your accounting process can eliminate the most common challenges in SaaS revenue recognition.
Whatever you do and whatever you need, there’s probably an app or a tool for that.
You, too, have probably created products that simplify people’s lives and reap the benefits of savings, increased productivity, and better management.
When you’re a SaaS company, automation is at the core of your business.
So why not apply automation to your accounting?
Revenue recognition software allows businesses to optimize their accounting process. Getting the right software can help you save time and improve accuracy.
Regpack is one of the solutions you can consider for revenue recognition management. On a single platform, you can easily manage your payments, discounts, financial statements, and sales reports.
Its integrated payment processing lets you track and report billings accurately.
Also, if you have many products and services, you can customize payment forms with Regpack.
Another great feature is that you can filter revenue data for specific customers or products so your reports can be customized for everything you need.
To sum up, the right solution for all your revenue recognition troubles is automation—the challenge is finding the right software for it.
Now that you know the most common challenges to SaaS revenue recognition, you can avoid them by implementing the right solutions.
Invest in the right automated software solution to comply with laws and regulations and have accurate metrics for your financial status.