We’ll spare you the thrilling explanation of revenue recognition that you’ll find in the Accounting Standards Codification (ASC) – the authority on generally accepted accounting principles (GAAP).
Just know this: To recognize any payment you receive as revenue, you must first deliver the product(s) or service(s) entirely.
A hipster walks into a Doc Martens shop and buys a pair of high-top boots. Your mom got a flat on her way home, and so she made a pit stop to have a new tire put on. You took your dog to the groomers, and now Fluffy’s got a new du.
All of the above are examples of revenue recognition happening immediately after a transaction. Hipsters can wear new Doc Martens immediately following the purchase. Your mom drove on her new tire as soon as it was put on, and Fluffy’s groomer got paid as quickly as Fluffy got his hair did.
As you might imagine, in SaaS, revenue recognition gets a little more complicated. Our customers have access to our services immediately. However, we’re typically paid a subscription fee as monthly recurring revenue (MRR), or we receive payment up-front for an entire year’s subscription.
Revenue is recognized after you deliver your goods or services. If your customer pays you for a year’s worth of software access – yeah, you’ll get the cash up front. But, you can’t count that cash as revenue right away. Instead, you count it over the course of the year, one month at a time. The cash that you can’t count as revenue is called deferred revenue.
Here’s an example
If Customer A pays $1,200 for a yearly subscription, then you’d recognize $100 of revenue each month until the year has ended. If Customer A pays $1,200 up-front on January 1st, then you’ll recognize $100 in revenue at the end of January (or top of February depending on your billing cycles).
Mandatory fees and extras
Let’s say you also provide a mandatory set-up service. Customer A must also pay $300 up-front to have your team handle installation. You might assume that the $300 fee gets recognized immediately, but hold your horses…
Because it was mandatory – meaning, the customer HAD to purchase it to use your software subscription – then it gets counted as part of the yearly mix. So, you’re looking at the original, annual fee of $1,200 plus the $300 installation costs for a total contract value (TCV) of $1,500. You’d recognize $125 in revenue per month ($1,500/12 months = $125).
Optional fees and extras
Let’s say your set-up fee is optional. It’s an upsell that you’d like for each customer to purchase, but it isn’t necessary or mandatory. Therefore, your company considers this installation fee as a separate product. In this example, since the set-up fee is a separate product, you can recognize the revenue after you’ve completed the installation.
So if you’ve got a total contract value (TCV) of $1,500, where a set-up fee is an extra option, then the $300 fee gets recognized immediately, and the remainder of the contract is recognized as revenue over the course of the year, on a month-to-month basis.
Takeaway: Have an accountant
Revenue recognition is just one of many tricky issues when it comes to counting your money correctly. Just remember, if you’re ever in doubt, ASK AN ACCOUNTANT. You must have one, even if you’re flying solo. A good accountant is worth their weight in gold.