Founders, as you embark on your journey of starting your SaaS-based business, one thing that will come up time and time again will be the concept of “revenue recognition.”
That, of course, begs the question: what is revenue recognition?
In short, it’s the process of recognizing revenue received from customers at the right time periods for financial statement purposes. That can get more complicated than you may initially think, so it’s worth taking a closer look.
Let’s start with an example
Tagore, Inc., a SaaS-based business, signed a customer for an annual contract to use their platform. The contract was signed on January 1, 2022 for $12,000 and so, on that date, the customer paid Tagore, Inc. $12,000.
The question becomes: when should Tagore, Inc. recognize this revenue? On a cash basis of accounting, the revenue would be recorded in January 2022. You can see how their books would play out for the remainder of the year.
|January 2022||$ 12,000.00|
|Total Contract||$ 12,000.00|
That cash basis doesn’t necessarily accurately reflect that Tagore, Inc. will continue servicing that client throughout the whole year. To provide a clearer picture, according to generally accepted accounting principles (GAAP), the company should use accrual-based accounting.
On an accrual basis of accounting — and here’s the tricky part — this revenue needs to be spread over the life of the contract. That would mean recording $1,000 each month for the 12-month duration of the contract. Let’s take a look at how that would play out in Tagore, Inc.’s books.
|January 2022||$ 1,000.00|
|February 2022||$ 1,000.00|
|March 2022||$ 1,000.00|
|April 2022||$ 1,000.00|
|May 2022||$ 1,000.00|
|June 2022||$ 1,000.00|
|July 2022||$ 1,000.00|
|August 2022||$ 1,000.00|
|September 2022||$ 1,000.00|
|October 2022||$ 1,000.00|
|November 2022||$ 1,000.00|
|December 2022||$ 1,000.00|
|Total Contract||$ 12,000.00|
Why revenue recognition matters — and how to do it well
Why is revenue recognition so important? Because in order to appropriately scale your business and manage your runway, you need the clearest possible idea of your current and future financial state. You get that with accrual-based accounting.
Plus, many investors require startups to follow GAAP, which means you’ll need to implement accrual accounting at your business. And by the time you hit $25 million in annual revenue, you’ll be legally required to use accrual-based accounting, too. So you may as well start using this method now.
So, how do you as a founder record revenue in your books? It takes some accounting background and knowledge, along with some familiarity with recording journal entries or using a system that is sophisticated enough to record revenue the right way. This can be complicated further due to the sheer volume of contracts your startup may be signing up with your customers.
Beyond all of that, one of the things that you as a founder need to pay attention to here is the interaction between the income statement and balance sheet when it comes to deferred revenue. Essentially, deferred revenue (the revenue yet to be earned) is reflected on the balance sheet. As the contract terms are met, the revenue moves from the balance sheet (deferred revenue account) to the income statement (revenue account).
In addition to the complexities mentioned above, you should also consider some additional revenue recognition standards as prescribed by GAAP, including revenue from contracts with customers (ASC Topic 606).
To help you dig deeper into this topic, we recommend this guide to revenue recognition best practices from the American Institute of Certified Public Accountants (AICPA).
Essentially, learning about and using this revenue recognition standard provides your company with the steps that it should take before revenue is recognized. And this can provide critical clarity to help your startup succeed.
If your startup is an Enterprise SaaS business, you may also find that you have implementation/set-up or non-recurring engineering revenue. ASC-606 must be taken into account when determining how this revenue, which is separate from your monthly recurring revenue (MRR), is recorded.
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There are solutions
Are you feeling overwhelmed? We just threw a lot at you. Fortunately, there are tools to help, ranging from simple to complex (and from low-cost/labor-intensive to high-cost/setup-intensive options). We’ve highlighted two below for you to consider.
Microsoft Excel or Google Sheets
At an early stage, it may be possible to keep track of your contracts using a spreadsheet. Adjustments can then be made manually in the accounting software.
This generally only works for startups in their earliest stages. But if money is extremely tight, this can be a low-cost way to keep your finances in order.
Stripe – Revenue Recognition
As you grow, accurately recording revenue requires an increasing amount of work. To automate a lot of the heavy lifting there, we’re seeing more and more clients turn to Stripe.
Their revenue recognition tool builds in compliance with things like ASC 606 and makes accrual-based accounting much simpler. It clearly breaks out deferred and recognized revenue and can even handle more complicated scenarios like upgrades, downgrades, prorations, refunds, and disputes.
Delivering all of this into automated dashboards and reports, Stripe can give you the clear financial picture you need to make informed decisions as you grow your startup.
If you want a way to streamline your accounting, gain visibility into your business, and adhere to GAAP, check out Stripe’s revenue recognition. Its popularity has skyrocketed in recent years for good reason.
Our team loves the nitty-gritty of tackling revenue recognition and we embrace it like a puzzle that needs to be solved. If as a founder, you want tackling revenue recognition to be one less thing on your to-do list, please contact us to find out more. We can help you choose the right solution — including thinking through the cost/benefit of implementing it — depending on the stage of your business growth.