What is revenue recognition?
At its core, revenue recognition is when you record revenue after it has been earned. It merely means the revenue belongs to you entirely after you’ve delivered the product.
Let’s say you run a leadership training business, and you offer a training program for $500/session. You sold one session in January to Customer A. As soon as the sale is done, you can recognize $500 as revenue in January. Done and dusted. There is no repeat sale from Customer A. To generate more revenue, you move on to new sales with Customer B, C, D, and so on.
Revenue recognition is straightforward and easy to understand when your revenue depends on selling one-off products or services. But what does that mean for subscription-based companies?
We’ll use Software-as-a-Service (SaaS) businesses as an example.
A common mistake: revenue recognition for SaaS businesses
We know that subscriptions are the lifeline of SaaS companies. That means SaaS companies must track the money that flows into their account and recognize their revenue correctly.
While revenue recognition is an ongoing priority in companies, many are still doing it incorrectly–that spells hassle (with a capital H) down the road.
Assuming you offer subscriptions for $100/month, your customers can opt to sign up for a monthly, quarterly subscription, or annual subscription.
When your customer signs up for a monthly subscription
Revenue from monthly subscriptions is easy to recognize. Customer signs up, revenue recognized. Customer renews subscription for another month, revenue recognized. That goes on until the customer cancels their subscription. Easy peasy.
Let’s say a customer signs up for a monthly subscription in January and cancels in June. Your revenue recognition looks like this:
When your customer signs up for a quarterly subscription
Customers who sign up for a period-specific subscription pay upfront for services that will be delivered over that period of time.
Let’s say the customer from the above scenario signs up for a quarterly subscription of $300 in January instead. Can you immediately recognize the lump sum as revenue?
The answer is no.
Many SaaS companies make the mistake of recognizing revenue like this:
This is a big no-no. Now it seems like you’re not generating any income from February onwards. The correct way to recognize the revenue for this sale is:
When your customer signs up for an annual subscription
Similarly, when the customer signs up for an annual subscription of $1200 in January, the correct way to recognize this revenue is:
Why can’t I recognize the amount stated in the invoice?
If you are selling a one-off service or product for $1200, then you can recognize the entire sum you received from the customer.
But you’re not. You’re selling period-specific subscriptions that “deliver” your product or service to your customers over a period of time. You don’t entirely own that revenue until you have completed each “delivery”, even if it has been paid into your account.
If I don’t own that revenue immediately, who does?
According to any GAAP (Generally Accepted Accounting Principles), any unrecognized revenue still belongs to your customer even if they’ve made an upfront payment. Whatever revenue you don’t recognize for the month is known as deferred revenue.
Deferred revenue is recorded as a liability in your Balance Sheet. This liability or “debt” gets smaller every month until the end of the subscription period.
Using the above example, this is how your deferred revenue and cash balance look when your customer signs up and pays for an annual subscription.
And this is how your revenue recognition and deferred revenue will look when your accountant closes your January bookkeeping.
|Def. rev||1200-100 = 1100|
...and so on.
Take a deep breath and give it a moment to sink in.
Revenue recognition looks straightforward but feels complicated at the same time. Don’t worry. You’re not alone. Let’s take a look at a few examples, and you’ll get a better hang of it.
We’ll keep the variable of $100/month for the following scenarios.
Scenario 1: Three customers with annual subscriptions, no new customers after that
Assuming you have three customers who signed up for an annual subscription in January. You received a payment of $3600 in total ($1200 x 3). Your revenue recognition is as such:
Remember, you don’t recognize the entire sum of the invoice in January. Otherwise, it would look as though you have a total revenue of $3600 and no income in the following months.
Scenario 2: Sporadic new customers
Let’s continue to build on Scenario 1. Now, assuming you have new customers signing up for both quarterly and monthly subscriptions. Your variables are:
- January - Customer A, B, C with an annual subscription
- May - Customer D with a monthly subscription, cancel at the end of September
- July - Customer E with a quarterly subscription, no renewal
Therefore, your revenue recognition looks like this:
Scenario 3: New customers + expansion from two existing customers
In this scenario, let’s assume that you get four new customers with monthly subscriptions (no end date) during February. Two of your existing customers upgraded their subscriptions with add-ons valued at $20/month during May. Your variables are:
- January - Customer A, B, C with annual subscriptions
- February - Customer D, E, F, G with monthly subscriptions (no end date)
- May - Customer A and B upgraded subscriptions with add ons ($20/month x 2 = $40 / month).
Therefore, your revenue recognition looks like this:
Scenario 4: New customers + non-recurring revenue
Let’s keep all variables in Scenario 3. Assuming Customer D also decided to purchase an onboarding package valued at $500 from you during February. This is how your revenue recognition looks like:
You will have a revenue of $900 during February. But it is a one-off addition because it is non-recurring.
Go deeper: Recurring vs. Non-recurring revenue.
You get the gist of it. Revenue recognition is not as complicated as it looks.
Daily recognition vs. monthly recognition
You may wonder: What if I bill my customer for an annual subscription on January 31? Do I recognize the entire sum of $100 for January? Or do I recognize $3.33 for January 31 only?
You can recognize your revenue on a daily or monthly basis. Neither way is wrong. While daily revenue recognition gives you a more accurate picture, it is also much more complicated and needs a software to do the job.
Monthly revenue recognition is easier to do. The question is, should you make your life easy and divide the sum by 12 months no matter what?
The choice is yours.
Hang on! Do I need to recognize my sales tax as well?
You don’t recognize sales tax in your revenue recognition. For example, if you have a Value Added Tax (VAT) or sales tax of 24%, then the total amount on your invoice for an annual subscription is $1488.
$1200 + VAT (24%) = $1488
You would only recognize $1200 in your revenue recognition, and not including the additional $288.
(In other words, you won’t get to keep that additional $288 because you’ll pay it to the tax authorities. Therefore, it doesn’t count as revenue.)
It’s crucial to recognize revenue properly from the beginning because...
The obvious answer is, it’s better to get things in order from the get-go, so you don’t have to deal with clearing up hassle later down the road.
But more importantly, incorrect revenue recognition affects your:
- Perception of the overall performance of your SaaS business
It will be challenging to figure out your company’s financial performance and overall performance of your business when you have $200,000 revenue in one month and only $50,000 in the next month.
- Calculation of your metrics
To correctly calculate metrics such as Average Revenue Per Account (ARPA), you need to know your Monthly Recurring Revenue (MRR). Without that, it will be harder to assess other metrics such as Customer Lifetime Value (LTV) and CAC payback time.
The five key metrics to look into during a valuation are: MRR, Annual Recurring Revenue (ARR), growth rate, Net Revenue Retention (NRR) rate, and gross margin. You can imagine how an incorrect calculation of your metrics impacts the valuation of your company.
- Financial reporting and forecasting
Not only is it harder to get an accurate picture of your company’s overall performance, but it is also challenging to do your financial reporting and forecasting. Making business decisions based on inaccurate data is a considerable risk. Not to mention, it also causes a lot of confusion for your investors! That’s probably the last thing you want to do if you’re looking for more funding.
Revenue recognition is key to making accurate growth forecasts. Many startups tend to get it wrong during the first few years of operation.
The verdict? They end up making wrong business decisions, or worst still, find themselves unable to close funding rounds in order to keep the business going.
The idea of it may feel intimidating at first. But it is relatively straightforward once you get the hang of it. When you do, other metrics become easy to understand, and you’ll be ready to run your business like a seasoned CFO.