Software compliance is inaccurately portrayed by standard accounting guides, being assumed to be a simple calculation where every customer will sign a clean annual agreement.
The financial department of a business does not operate with the same assumptions about how software compliance is recorded as do standard accounting guides. Finance teams will experience multiple different factors leading to discrepancies between the actual done date of contracts, use meter readings, and bundled products, prior to the monthly close.
This guide will clarify how the finance professional implements the applicable SaaS revenue recognition compliance processes on their company’s contracts that include all types of hybrid programs, utilizing both manual spreadsheets and automated general ledgers.
The Basics of SaaS Revenue Recognition: Cash Flow vs. Earned Income
Cash collected from a customer is not earned income to the business until the service has been rendered. Recurring billing models create a legal requirement to then provide the service "over time" by collecting cash at the beginning of the contract from the customer.
Take, for example, Stripe’s position that if a customer pays for one full year of service in one single payment at the beginning of the contract, then this cash cannot be considered top-line revenue immediately upon receipt. Instead, the collected revenue must be recorded as deferred cash until the period of service delivery has been completed each month.
When the physical delivery of services is taking place, finance departments will transfer dollars from their liability accounts (deferred revenue) into earned-income accounts to properly reflect the earned income.
In Chargebee's standard example, when the finance department moves the $1,000 from deferred revenue to recognized sales revenue, that is the proper representation of this accounting action. Mixing collected cash (which is a liability) and earned cash (which is paid as earned income) will create a confusion of financial metrics, inflate short-term margins, and create compliance risks during a financial audit.
Why Traditional Accounting Systems Fail Growth Companies
Traditional general ledgers and other entry-level accounting products have been designed to be used for sales of goods where payment and product delivery occur together. The ability of these systems to deal with recurring contract modifications, partial refunds, and ongoing service obligations is not present in most accounting systems.
As growth takes place in the software industry, the administrative burden of tracking recurring obligations for SaaS revenue recognition will become increasingly difficult and create a significant workload for the accounting departments who must track these obligations manually using basic accounting software.
Due to the lack of a structured way of predicting monthly revenue schedules, accounting departments must rely on custom spreadsheets to do so. As the complexity of the deals increases, the likelihood of custom spreadsheet setups falling out of sync with customer billing systems and sales systems increases, causing the close process to be delayed and prone to error.
Identifying Rules for Complex Contracts
The ASC 606 framework defines how to identify performance obligations for complex contracts. The identification of enforceability and the identification of separate performance obligations must be done first in accordance with the ASC 606 and IFRS 15 standards.
A contract is enforceable only if it contains clear terms for payment, has commercial substance, and is likely to result in collecting payment. Within a single agreement, a software vendor may have separate components of the contract, including software access, implementation support, customization, and ongoing support/maintenance.
It is important to evaluate each component of a contract to determine whether or not the component has distinct value to a customer independently of any other items in the agreement. For instance, if a customer can utilize the software without additional customization, then a charge for a set of tools needed for implementation is a distinct performance obligation as well.
However, if the implementation is highly specialized, and without it the software will not function properly, then the software access and the setup charge must be combined and treated as one performance obligation to recognize revenue over the entire customer life cycle.
Pricing and Splitting the Contract Amount
After identifying each obligation, finance must determine a total transaction amount of the contract price and allocate it according to the standalone selling price (SSP). Pricing on standard lists often differs from final amounts as many contracts include reseller discounts and/or bundled service offerings.
Accounting rules require that the transaction amount should be allocated relative to the market value of each component when sold individually (i.e., at SSP).
Oracle demonstrates one example of how a vendor would determine the total transaction amount on a 12-month contract that is billed at $100/month. The total contract amount of $1,200 includes physical and network equipment. The vendor’s allocation of the total transaction amount consists of a one-time charge for the hardware ($285.60), which is allocated when the hardware is delivered, and $76.40/month for network service provided each month throughout the term.
In another example provided by Finlens, an enterprise agreement is split into a software license for $20,000 and a setup fee for $5,000. If the service provided during setup has its own independent market value, then that fee would be recognized once the installation is complete. The software license ($20,000) would be recognized evenly over the term of the subscription.
When to Record Revenue for Ongoing Services
Obligations may be fulfilled either at one point or over a period of time. Access to platforms that offer continuous services is satisfied over time, while ongoing access to the platforms’ benefits is consumed by the customer on a daily basis.
Growthy highlights that the entire value of an annual subscription of $30,000 must be recognized monthly, as $2,500, across twelve months, regardless of whether the customer remitted payment at one time or over time.
Obligations fulfilled at one specific point in time will include immediate fulfillment of specifically defined obligations (such as hardware delivery or a completed technology migration). Misapplication of point-in-time pricing structures occurs when finance teams utilize point-in-time pricing upon the commencement of an ongoing service model or utilize point-in-time pricing across long durations of subscription deliverables.
How to Handle Usage-Based and Hybrid Models in SaaS Revenue Recognition
Handling Onboarding and Setup Fees
Upfront fees often represent significant sources of accounting errors in software-based finance. Where there is no transfer of a distinct additional service from onboarding to the customer, then the upfront fee cannot be recognized as upfront revenue.
Instead, the goods and services should be included within the total value of the overall contract and recognized over the term length of the core subscription or anticipated lifetime of the customer.
When implementing, if a client was also receiving separate advisory consulting services that provided an independent benefit to the client, then the finance team would be able to recognize that separate portion of fee revenue at that time as and when relevant milestone events have occurred.
The appropriate segmented breakdown of each aspect of the service should be thoroughly documented to include clear definition and identification of market level of services and separation of services on a daily operational basis from the core main platform on which each was based.
Accounting for Usage-Based Billing and Overages
Due to the inclusion of usage-based pricing structures, the inclusion of variable consideration makes the management of the monthly cycle complicated for finance teams when determining the amount to be recognized as revenue within a month. When a customer is paying for API call volume, active seats, or the volume of data processed, the amount of revenue received each month would fluctuate.
As such, finance teams must estimate usage, and then either accrue or defer the related revenue to the month in which it is actually consumed; whereas, if it has been consumed, it must be recognized only at that time of billing cut-off of the account at month-end.
If the metering and reporting for usage of the software is late or has any inaccuracies, then the financial reports processed will be inaccurate. In order to develop a reliable process that accurately counts all of an individual client's usage during any given accounting period, it will be necessary that the operational group provides the finance team with sufficient reliable links through the data warehouse, the usage metering, and the general ledger.
This is imperative to confirm the appropriate accounting periods for the excess usage charges for each client.
Managing Contract Changes and Downgrades
Generally speaking, contracts are not static. Typically, during the course of clients' engagements with the software provider, there are many instances where clients upgrade their number of active seats or licenses, add additional modules to the software that they purchased, request temporary discounts, or downscale their requirements while still being a client.
ASC 606 defines three types of modifications to existing contracts: separate contracts (when prices change due to new deliverables), prospective adjustments (when there are additional deliverables without a price change), and cumulative catch-up adjustments (when there is a price increase without additional deliverables).
When additional services are added at their standalone selling prices, the contract modification is treated as a separate contract because they were not previously sold as part of the original contract. When additional services are sold at prices lower than their standalone selling prices (e.g., discounts) and do not meet conditions for standalone selling prices, the total amount of unearned revenue is combined with the new contractual fee and recognized prospectively over the remaining contract term.
As companies experience growth in their contract volumes, they typically use manual spreadsheets and create custom formulas to calculate the amounts owed to customers. Unfortunately, this approach leads to a greater likelihood of calculation errors being hidden within the formulas.
Sales personnel often modify payment terms without consulting the accounting department, which represents a significant audit risk to the company.
The usage data held within external billing systems does not align with the cut-off date used to generate the general ledger.
The allocation of standalone selling prices is often overlooked by sales staff who are giving unapproved discounts to customers.
The following describes the mechanics of recording entries related to deferred revenue into the general ledger, along with examples of how to enter them into the general ledger during the monthly close.
Accounting Steps and Monthly Close Processes
Standard Record Entries for Deferred Cash
In order to maintain a proper accounting database, it is essential to keep disciplined records for each step of the contract lifecycle. For example, upon the execution and invoicing of a pre-paid annual contract for $12,000 (the "contract"), the first journal entry would include the following:
Debit (debit amount): Accounts Receivable - $12,000
Credit (credit amount): Deferred Revenue - $12,000
No revenue will be recognized as "earned" on the income statement as of the date of invoicing. When payment is received, the journal entry would then include the following:
Debit (debit amount): Cash - $12,000
Credit (credit amount): Accounts Receivable - $12,000
At the end of month one, the company would then recognize the first month of revenue under the contract by making a monthly ratable recognition entry including the following entries:
Debit (debit amount): Deferred Revenue - $1,000
Credit (credit amount): Subscription Revenue - $1,000
This process of SaaS revenue recognition will continue until the deferred revenue account reaches a zero balance.
Matching Invoices, CRM, and the Accounting System
To maintain accounting integrity, organizations using a sales CRM (e.g., Salesforce) require ongoing three-way reconciliation with billing systems (e.g., Stripe or Chargebee) and the accounting system (general ledger). The amount billed must match the amount represented by the sales contract in the CRM.
The amount charged in the billing system must match the revenue recognition schedule in the accounting system. Many customer contracts include discounts or custom contract terms. When this occurs, a simple change in contract terms may disrupt the flow of information among systems.
Whenever a customer’s contract is changed in the CRM, operational checkpoints must verify that the change was also made in the billing system to update both revenue recognition and billing information simultaneously. Failure to do so can result in incorrect financial statement reporting due to the introduction of manual data entry errors.
Audit Preparation and Internal Checks
External auditors do not necessarily only check final balances; they also review the internal control system, their documented processes, and the logical flow of documentation.
As members of the finance team develop audit preparation documentation, they must maintain complete and unbroken historical records for every dollar that moves from contract to revenue recognition.
In order to prepare properly for an audit, finance teams must record and properly document their standalone selling price selection process, any changes to contracts, and the monthly reconciliations completed on a timely basis to prevent possible disputes with auditors and/or reviewers.
Modern Software Tools and Costs
When to Upgrade Your Accounting Software
Many companies rely on spreadsheets to document revenue during the product launch phase, but that methodology has limitations as package complexity increases. As companies move toward multi-element contracts, integrated mid-contract modifications, and price based on usage, they must implement an automated revenue management system.
The amount of time needed to complete the financial closing process, when using manual data validation techniques, can be many weeks; therefore, this timeframe will increase the likelihood of an incorrect report that may cause disputes over reporting errors.
Automated revenue systems allow companies to process the most complex contract structures, to automate revenue schedules, to support the recurring monthly journal entries, and to transfer those entries directly to the accounting system.
Looking at Current Software Options and Pricing
When researching available software solutions supporting companies with distinct ARR stages and operating sizes, consider contract complexity, available internal technical resources, and overall budget limitations when selecting the appropriate software stack.
Maxio provides a niche subscription analytics and revenue management solution for growing B2B SaaS companies at an approximate monthly fee of $599.
QuickBooks Online Advanced can be obtained for approximately $117.50 per month; it provides a basic automated revenue recognition solution for simpler types of subscription businesses.
Tabs charges around $1,500 per month for an automated contract ingestion model that processes custom contracts into revenue schedules.
Stripe Revenue Recognition is based on 0.25% of recognized revenues; it integrates seamlessly with your Stripe billing pipeline to enable automated deferred revenue accounting.
NetSuite charges $129 per user per month; in addition, the expected implementation cost ranges from $30,000 to $100,000+, and provides enterprises with comprehensive enterprise resource planning solutions.
Alguna provides an entry tier free of charge. Paid plans begin at $699 per month for automated revenue recognition processes.
Many other providers, including Sage Intacct, Chargebee RevRec, Zuora Revenue, LedgerUp, Finlens, Leapfin, and RecVue, provide tailored solutions which include both subscription management and enterprise ledger automation applications.
Automated contract ingestion that processes variable billing information directly from the deal in your CRM.
Native integration with usage-based metering systems to allow for real-time overage billing.
History audit trails that track all prior schedule changes and manual modifications.
Flexible multi-currency support is essential for enabling organizations to comply with various local tax regulations across multiple jurisdictions.
Making Smart Choices for SaaS Revenue Recognition
Compliance is more about operational data than it is about theoretically understanding the accounting rules. Approaching revenue recognition as simply an annual audit task will ultimately result in longer monthly close cycles, data inaccuracies, and misstatements.
Long-term revenue recognition accuracy relies on well-defined, real-time processes connecting sales activities, billing events, and general ledger records.
Finance teams need to define how they will determine their standalone selling prices based on customer experience and market trends; establish consistent reporting guidelines; and eliminate manual, spreadsheet-based recording of contractual agreements, especially once they begin executing higher volumes of contracts.
By investing early in automated financial reporting solutions and reliable data pipelines, an organization can establish its financial integrity, foster the development of trusting relationships with investors, and create a predictable way of executing compliance going forward.
Common Questions About Revenue Rules
What to Do When a Customer Downgrades a Contract
In the event that a customer downsizes their contract by decreasing seat counts or eliminating modules mid-contract, finance teams must evaluate whether the change in contractual obligations requires a prospective adjustment or an adjustment for cumulative amounts.
If the remaining services or products sold to the customer are distinct from those already provided, the remaining unearned deferred revenue associated with the customer's downgraded contract will be combined with any change in contract provision terms prior to the adjustment and the resulting revenue will be recognized going forward into the future.
On the other hand, if the additional services or products sold by the customer are not distinct from those previously sold, the team must perform a cumulative catch-up entry to reflect any adjustments to recognized revenue.
How to Record Free Trials and Usage Credits
Free trial promotional usage credits can be considered variable consideration, or alternatively, they may be viewed as marketing expenses depending on how the credits are structured.
Free trials will not generate SaaS revenue recognition entries while they are taking place; there is no amount of liability associated with providing a service until it is paid for, and there is no enforceable right to a payment during the free trial time period.
However, the use of credits to resolve issues related to a customer's service performance would reduce the total value of the transaction to the customer and should be treated as a reduction of recognized revenue over the term of the contract, not as operating expenses.
How to Avoid Mismatches Between Billing and Accounting
Reconciliation drift can occur when a customer has made payments through a billing application such as Stripe or Chargebee but those payment history entries do not match with deferred revenue schedules stored in the general ledger.
There must be ongoing automated weekly and/or monthly three-way matching activities with CRM contracts, billing records, and general ledger schedules so that any discrepancies can be identified and addressed as soon as possible.
In addition, all previous accounting periods should be blocked from being edited in both billing software and general ledgers to prevent any post-fact accounting activity from introducing undetected differences to the current accounting period report.
When to Move from Manual Spreadsheets to Software
If a business is new and has a small number of annual prepaid contracts, it would be able to maintain its SaaS revenue recognition billing schedule in spreadsheets.
However, once a company reaches around $2 million to $5 million in ARR, manual spreadsheets will generally no longer be effective, and processing contract documents will become increasingly difficult.
In particular, once a business begins introducing contracts with a higher volume of active accounts (greater than fifty), or begins incorporating different types of pricing plans (i.e., usage-based plans, bundling contracts with multiple products, custom enterprise contracts), manual processes will consume more time and will increase the likelihood of financial reporting inaccuracies.
