How Do Accounting Rules Impact SaaS Businesses?
When it comes to revenue recognition, SaaS companies have some special challenges, including additional considerations that require them to exercise a great deal of discretion in regards to when and how to recognize revenue and record expenses relative to other type of businesses. That will become even more challenging once FASB’s new accounting standards go into effect, beginning after 2016 for public companies and after 2017 for private ones.
The main distinction between SaaS companies and other types of software businesses lies in how they deliver their products. For software product companies, customers take physical possession of the software. In SaaS companies, since software is hosted/cloud-based, with the provider retaining control of the software, the transfer never occurs: hence software as service.
What current accounting rules say about revenue recognition
According to FASB, “An entity should recognize revenue when (or as) it satisfies a performance obligation by transferring a promised good or service to a customer. A good or service is transferred when (or as) the customer obtains control of that good or service.”
- Normally this would be when the software is delivered. With SaaS businesses, since there is no date when the software physically changes hands, when should they record revenue?
Companies providing cloud-based software have to recognize the associated revenue over the length of the contract, not upfront. For FASB this means, “an entity shall recognize revenue over time by consistently applying a method of measuring the progress toward complete satisfaction of that performance obligation.”
Revenue recognition and subscription models
And that’s where one of the challenge lies. Since SaaS companies most often adopt a subscription model, they need to not only recognize revenue over the term of the subscription, in addition, they need to estimate the “expected average life” of their customers.
Contracts with multiple elements — what’s this?
SaaS companies also typically have contracts that include multiple deliverables (i.e., software and related service components), referred to under accounting rules as multiple elements. When determining when and how to recognize revenue, companies need to assess these deliverables on the basis of whether the various elements have standalone value.
Companies need to clearly delineate the key aspects of their service/product offerings and the related charges, in their contracts. Having an accounting professional review language related to setup fees, prepayments, storage fees, and data capture fees in particular is really helpful since this is where companies often trip up and it is where auditors will focus.
How can Saas startups comply with accounting principles
In order to comply with accounting principles:
- Revenue can only be recognized when certain criteria are met, including the existence of an approved contract that outlines rights and payment terms, and delivery of the software or services.
- Revenue should be allocated among components based on the estimated selling price of each on a standalone basis (determined as among other things, having value to the customer, whether they are sold separately by other vendors, and their ability to be resold on a standalone basis).
- The portion of the fee related to services (versus product) should be recognized separately as they are performed, subject to specific criteria being met.
The last two requirements illustrate another key challenge: namely what to do when trying to determine the value of set-up fees and services that can’t be separated from software (product) use.
The requirement to use estimated selling prices will often require SaaS companies to perform additional analysis. It also gives them wide latitude to make judgment calls as to the standalone value of the other services they provide and assumptions as to the average life of their customers.
SaaS financial statements under new accounting rules
When the new accounting rules go into effect, businesses will need to more clearly document, support, and explain what constitutes separate performance obligations, how they determined transaction prices for the relevant performance obligations, as well as how they arrived at their other assumptions via meaningful disclosures so that those reading their financial statements can understand and compare results across companies.
Take a look at a previous post on revenue recognition, for more details on the new rules.
David Ehrenberg is the founder and CEO of Early Growth Financial Services, an outsourced financial services firm that provides early-stage companies with accounting, finance, tax, valuation, and corporate governance services and support. He’s a financial expert and startup mentor, whose passion is helping businesses focus on what they do best. Follow David @EarlyGrowthFS.
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