Demystifying the complexities of revenue and how it's tracked and recognized in SaaS businesses

What is revenue in SaaS businesses?

The simple definition for revenue as it relates specifically to SaaS businesses is that it is the amount a company has “earned” by delivering contracted services during a specific period. It's an important metric to understand as the subscription-based and usage-based pricing models used in SaaS can make financial reporting more complex than it is for traditional businesses.

Revenue also provides the basis for key performance indicators (KPIs) like monthly recurring revenue (MRR) and annual recurring revenue (ARR), which are important pieces of a SaaS company's financial picture.  

Here are some key characteristics of revenue, including how it should be reported and recognized: 

• Accrual-based accounting: SaaS companies typically use accrual-based accounting, where revenue is recognized when services are delivered or contractual obligations are met—not when customers are billed or payments are made.
• Gradual recognition: Let's assume that a customer makes an upfront payment for a year's subscription. This revenue isn't recognized all at once. Instead, it is “earned” gradually over the year, with each month accounting for one-twelfth of the annual subscription cost.
• Performance obligations: Revenue is recognized only when specific performance obligations are fulfilled. For a SaaS company, this usually means providing a full period (e.g., one month) of access to the product as specified in the contract.
• Financial reporting: In contrast to financial metrics like bookings and billings, revenue is included in financial statements. Revenue appears on the profit and loss statement (P&L or income statement), while deferred revenue appears on the balance sheet.
• GAAP compliance: For public SaaS companies in the United States, revenue must be calculated and recognized according to generally accepted accounting principles (GAAP), which are standardized rules that ensure consistency and transparency in financial reporting. Thus revenue is a reliable metric for investors when they want to review the profitability and performance of SaaS companies. While private companies are not required to adhere to GAAP principles, doing so is a good idea, given the importance of accurate and standardized financial reporting to potential investors. 
• ASC 606: In 2014, the financial accounting standards board (FASB) introduced ASC 606, a standard that provides specific guidance on recognizing revenue from software products. Public companies must comply with these standards for legal and regulatory reasons. However, as with GAAP principles, private companies can benefit from the guidance ASC 606 provides. 
• Lagging indicator: Revenue is a lagging indicator, reflecting past performance rather than future potential. This contrasts with metrics like bookings, which is a more forward-looking metric.

Let’s see how revenue as a standalone metric compares with other revenue metrics, such as ARR, deferred revenue, remaining performance obligation, bookings, etc. 

Revenue vs. deferred revenue:

As discussed, revenue is the amount that has been earned and recognized in your company’s P&L statement for the services delivered. 

On the other hand, deferred revenue is the payment received for services that have yet to be delivered. It is a liability on the balance sheet until the service is provided and the revenue is recognized.

Revenue vs. remaining performance obligation:

In contrast to revenue, the remaining performance obligation (RPO) represents the total amount of contracted services not yet delivered or recognized as revenue. It includes both invoiced amounts (deferred revenue) and non-invoiced amounts that will be billed and recognized as revenue in the future.

Revenue vs. ARR

Revenue is historical and recognized over time (lagging indicator). 

Conversely, ARR is a forward-looking metric that predicts how much recurring revenue a company expects on an annual basis from its current subscriptions.

Revenue vs. bookings

Revenue is recognized as services that are delivered over a specified time period. On the other hand, bookings represent the total value of contracts signed, regardless of when the revenue will be recognized.

Understanding these distinctions is important for SaaS businesses, as together, they provide a comprehensive view of a company's financial health (both current and projected). 

What is the revenue recognition principle?

Revenue recognition in SaaS is the process of converting cash from bookings into recognized revenue over time. 

In the good old days of software sales via a CD, a company would purchase a copy of a product, such as a customer relationship management (CRM) system, install it on its on-premises computer, and use it until a new version was released. In this scenario, it was simple, the entire sales price could typically be recognized as revenue at the point of sale.

However, today’s subscription-based transaction models are characterized by deferred revenue, as SaaS companies frequently collect payment in advance for services that will be delivered over time. A customer might pay upfront for a year's access to a cloud-based CRM system, but the SaaS provider can only recognize this revenue gradually as they provide the service over the course of the year. This creates a gap between when cash is received and when revenue can be recognized. 

The timing is crucial: revenue recognition typically begins on the service start date. 

For instance, if a customer's subscription begins on September 1, 2024, the SaaS company will start recognizing revenue for that customer at the end of September and continue doing so month on month for the subscription period.

Public SaaS companies must adhere to GAAP accounting principles and the new principle-based approach outlined in ASC 606 to determine when revenue can be accounted for in the financial statement and address any complexities. These principles also provide good guidance for private companies as well. 

The revenue recognition principle in SaaS emphasizes the importance of matching revenue with the period in which the service is provided rather than when payment is received. This approach provides a more accurate representation of a SaaS company's financial performance over time, allowing for better analysis and more informed decision-making by management and investors alike.

Revenue recognition criteria

ASC 606 established the following criteria for SaaS businesses to follow when recognizing revenue:

• Contractual right to software possession: Customers must have the right to take possession of the software at any time during the hosting period without incurring a significant penalty. This distinguishes between a software license and a service arrangement.
• Feasibility of customer-managed or third-party hosting: It must be feasible for customers to run the software on their own hardware or contract an unrelated third party to host it. This further emphasizes the distinction between a software license and a pure service arrangement.

These criteria, along with the broader principles of ASC 606, mean that SaaS businesses must work closely with accounting professionals to correctly interpret and apply these standards, as the specific application can vary based on each company's unique offerings and contracts.

How to calculate and recognize revenue for your SaaS business?

Understanding how to calculate and recognize revenue is crucial for SaaS businesses. 

Usually, total revenue is calculated by adding the company’s MRR and accrued revenue (not included in MRR), together with any variable income and non-recurring revenue as shown in the formula below:  

However, most SaaS companies consider several other factors when calculating revenue, as seen below: 

Understanding the steps in the SaaS revenue formula calculation:

• Sum up all recurring subscription fees for the period
• Add any usage-based charges or overages
• Include revenue from add-ons or overages, such as upsells (e.g., customers may have moved to the enterprise package) or cross-sells (e.g., customers have bought additional services) in that period
• Factor in any one-time fees (like implementation fees) that are recognized in the period
• Also, include any professional services revenue, such as premium support for the year
• Adjust for any deferred revenue from previous periods that is now being recognized
• Consider any changes in subscriptions (upgrades, downgrades, or cancellations)
• Subtract any discounts or credits applied

It's important to note that this calculation should align with GAAP standards and any applicable revenue recognition rules like ASC 606.

Example calculation of total revenue

Let’s consider the following example for our fictional company, Hotfix Inc., which sells subscriptions for its product Hotfix chatbot. Through Hotfix Inc., we have explained how a SaaS company’s finance and account team will “recognize” and record bookings, billings, and revenue.

Here are our assumptions regarding the bookings and contract details:

• Bookings amount: $118,000 for the first year, paid upfront
• Bookings date: January 1, 2024 (date of the signed contract)
• Contract term: 2 years
• Billing frequency: Quarterly (applicable in the second year. No billing in the first year since the payment has been upfront)
• Payment terms: Net 30 (payment due within 30 days of invoice)
• Service start date: May 1, 2024

And here are the assumptions we’ll use for our products and services: 

• Subscription from Hotfix Chatbot Pro licenses: $36,000 (10 licenses at $300/license/month)
• Subscription from AI Bot Autoresolver Add-on: $12,000
• Premium support (recurring): $5,000 annually, starting from service start date
• Implementation of professional services: $12,000 one-time fee, paid monthly in three installments 

Note that the service start date doesn't necessarily coincide with the bookings date. This gap between contract signing and service commencement is fairly common in SaaS companies and affects revenue recognition.

The tables below illustrate how Hotfix Inc., “recognizes” and reports revenue, and also accounts for bookings and billings, for its Hotfix chatbot product over the course of 2024 and the first quarter of 2025.

Note that Hotfix uses accrual accounting. As you can see in the tables, Hotfix recognizes its revenue and accounts for bookings and billings in the following manner: 

• The professional services fee of $12,000 is recognized over three months (YTD Feb–April 2024), the month after the services were booked.
• Revenue is “recognized” from YTD May 2024 onwards (since it is the start of service).
• Deferred revenue here is the total amount from licenses subscription and add-on), i.e., $48,000. It is recorded from YTD January 2024 onwards (the bookings date since the revenue is assured) and decreases monthly from YTD May 2024 onwards (start of service) as services are delivered month-on-month. Therefore, in YTD April 2025, deferred revenue = 0 (as the first year’s services are delivered in full).
• Quarterly billings will commence in the second year; therefore, it is recorded in July 2025 and October 2025. There are no quarterly billings for the first year as the payment was made upfront. 
• While not applicable in this example, RPO would represent the total amount of contracted services not yet delivered or recognized as revenue. It includes both invoiced amounts (deferred revenue) and non-invoiced amounts that will be billed and recognized as revenue in the future.

This example illustrates the complexity of revenue recognition in SaaS businesses and the importance of carefully tracking various components of a contract, including bookings date, service start date, implementation fee, overages, etc.  It's crucial for SaaS companies to have robust systems in place to track and manage these complex calculations and ensure accurate financial reporting.