Ask any SaaS company founder, CFO, or auditors and chances are they have all struggled with revenue recognition for their business. At the same time, any interested party wanting to acquire/partner a SaaS business, have often dealt with unpleasant surprises. SaaS revenue has proven to be too difficult to track and recognize accurately, we shall look into the reasons in this column.

Revenue Recognition, or Rev Rec as auditors like to call it, was often considered a problem for the accounting department, until SaaS came along and the whole economy took a detour through subscription models. Customers or Subscribers paid up front for SaaS products/solutions, and the cash register went, well, Cha-Ching! There was a catch though, cash wasn’t revenue exactly. So we got to Cha-Ching Cash Catch. Told you it gets confusing! Stay with me and I will declutter it for you.

Think of the time not too long ago when most customers purchased merchandise at stores, paid there and got done with it. Cash was earned and marked as a line item that went towards calculating revenue. If there was a return, it was processed separately under returns and allowances. This was the tried and tested method of Rev Rec for all businesses. No wonder SaaS businesses chose to adopt the same method. Except, subscriptions were different than traditional sales. A subscriber could pay upfront and subscribe for the whole year, only to cancel two months into the year. By that time, the company had already projected this sales towards the full year revenue; such returns could be significant. Another subscriber would just sign-up for the first free month or upgrade via some “freemium” plan, only to cancel once s/he had to pay. Typically a B2C subscriber would pay monthly, and want to pay as s/he goes. A significant percentage of B2C subscribers would only sign-up for the exact months they need the subscription and cancel out towards the end of those months. Moreover, some subscribers would sign-up for recurring charges, whereas most others would opt-out of that. B2B subscriptions would be whole another story. For the B2B subscriptions, sales contracts would be struck per license, but that could go up or down throughout the year. Revenue recognition became extremely complex with services or support were bundled with subscriptions, commitments to delivery of any non-standard functions/capabilities were made, or unachievable customer acceptance criteria were agreed upon. Billing, Service, and Accounting periods can all be spread across different fiscal years – further adding to the confusion.

Let us elaborate it via an example. Say, a B2C SaaS company has 500,000 subscribers who signed-up for $10/month plan. This business should go on to make 500,000*10*12 = $60M of revenue for that year. With half decent promotions and “bundling”, the business should be well on its way to $100M Revenue Run Rate. But in reality, the actual revenue could be anywhere between 0 and $100M, as subscribers could cancel in droves (and they have in many cases) or opt-out as and when they deem fit. Now suppose 100,000 of those customers subscribed during the Holiday promotions time in Nov-Dec, paid for their subscriptions by 31st December, only to cancel their subscriptions in Jan-Feb next year. Billing/Invoicing/Payments were completed in one fiscal year, and cancelled/refunded (partially or completely) in the next.

How to account for such Rev Rec?

And we have not even begun to talk about regulatory and compliance landscape. As with many other businesses before them, some SaaS companies tried to project an inflated corporate performance, so they adopted aggressive Rev Rec practices. Regulatory Boards and Agencies came cracking and established complex rules and guidelines to rein in such practices, especially for those that report earnings to investors or stakeholders. There are now structured rules and compliance standards like ASC 606 around how businesses should calculate and report revenue.

In short, it’s a mess. What’s the way out then?

Stay Tuned! More to follow..

(Or call us if you need immediate help!)