As the speed and reliability of the Internet has grown and evolved, one of the biggest shifts we’ve seen in the online business world is the shift to software as a service (SaaS).

More and more software companies have stopped developing and selling their software outright, opting to keep their software in their possession and sell the service it provides instead. The SaaS concept provides many benefits to these businesses, such as eliminating the hassle of installing, configuring, managing and upgrading the software,  but it also brings changes in the way they earn and account for their revenue. SaaS providers must keep in mind that the concepts of money and revenue are two different things.

In years past, software was sold, money was collected, the transaction was complete, and revenue was generated. Today the service is sold, most often through subscription plans based on months, quarters or years. Clients might pay at the beginning of a term, or at the end, or even change something somewhere in the middle. So when, exactly, is the transaction complete? When does the money collected from the client actually become revenue that must be booked per GAAP and IRS rules? Not knowing the answers to these questions can have legal and tax consequences.

The Concept Of Revenue Recognition

The basic premise of revenue recognition is that money collected from a customer or client is not counted as revenue until the product or service has actually been delivered. With many businesses, the collection of money and the delivery of a product or service happen at the same time, such as with traditional software sales. In this case, revenue recognition is immediate. This is not the case with SaaS providers.

Revenue Recognition As It Applies To SaaS

According to the SEC, revenue generated from subscription services should be accounted for as “nonrefundable up-front fees”. This would mean that revenue can not be recognized until all of the following four conditions are met:

• Persuasive evidence of an arrangement exists
• The seller’s price to the buyer is fixed or determinable
• Collectibility is reasonably assured
• Delivery has occurred or services have been rendered

With SaaS, agreement to terms that are set up at the time of subscription generally satisfies the first three conditions. That just leaves us with the last, a product has been delivered or services have been rendered. For the SaaS provider then, this means that even if you have cash in your hand, you can’t recognize it as revenue until you render the service that cash has paid for.

Here’s an example:

Let’s say a client purchases a yearly subscription that costs $12,000. The company will collect $12,000, but it will take one year for services to be rendered. Service will start at the moment the subscription is paid, and will continue each day for 365 days. Until that has occurred, the revenue has not been earned. If we break it down, the SaaS provider can recognize the revenue as the service is carried out. It could be recognized at a rate of $1000 per month, or $32.88 per day. The point is that the company can not recognize the total $12,000 in revenue until the year has passed.

Changes On The Horizon

After December 16, 2016 changes will be implemented to try to alleviate some of the confusion that has occurred from trying to fit the new SaaS business model into old accounting standards. Public companies will have to conform to the new standards at that time while private companies will be given the option to defer for one year. The upcoming changes will consist of a five-step process for revenue recognition.

1. Identify the contract with the customer - This can be a verbal contract or implied contract set up through agreement to terms during the subscription process.
2. Identify separate performance obligation in the contract - A performance obligation is any service you provide that your customer can benefit from and is separate from other services.
3. Determine the transaction price - This will be how much money you expect to receive for the entire service that you will provide.
4. Allocate the transaction price to separate performance obligations - Break down the total price into costs for each of the performance obligations you outlined in the step above.
5. Recognize revenue when or as the entity satisfies - Revenue is recognized, similar to our example above, for each of the separate performance obligations over time as service is rendered.

Key Points To Remember

• Money collected is not revenue until it is earned. Customers can request refunds or alter services in the meantime. If a client requests a refund and the money has already been spent, the company ends up in a risky financial situation.
• Recognizing revenue too early will lead to huge inaccuracies in financial reports, making it look like there is more money available than there really is, causing overspending
• Understanding how your finances work and knowing exactly when revenue is actually generated will allow you to see more clearly where your SaaS business currently stands and how to position it better for growth in the future.