It goes without saying that accurately recognizing revenue is important to understanding your business’ financial health. While you might have a good grasp on revenue recognition, things get a bit trickier in a software-as-a-service (SaaS) business. Revenue in this industry occurs over an extended period of time and software may be priced monthly, invoiced quarterly and tracked yearly for financial statements. Add in the fact that some customers may upgrade mid-contract or bundle several services together, and you’ve got yourself a moving target of a math problem.

How SaaS Revenue Recognition is Different

Just like any other business, SaaS businesses follow the revenue recognition principle laid out by the IFRS and U.S. GAAP. The difference lies in the industry’s unique delivery method. Customers don’t own the software, as they might have 10 years ago, so the transfer of the service happens incrementally as the customer uses it over the life of the contract. So, to assure accurate numbers for your accounting books and taxes, the value of the transaction must also be recorded as recognized revenue incrementally.

Because of this, earned revenue is spread out over the delivery period. Most SaaS companies track monthly recurring revenue, or MRR. This metric captures the revenue received from subscriptions and is one of the most important things owners and investors look at when monitoring the health and profitability of a SaaS company.

To calculate MRR, you have to account for three key metrics: bookings, changes to subscriptions and churn.

Monthly Revenue Recognition Breakdown

Bookings are more or less self-explanatory, in that the number captures the amount of money a customer has committed to spending. For an annual contract, which may include discounts for bundled services, the price is divided by 12 to reach the MRR. More tedious math is required when a customer buys software in the middle of the month. The revenue recognized for that month is broken down to account for the number of days the customer has had access to the software. The remainder of the prorated amount is accounted for in the same month the year following (that’s assuming the contract isn’t renewed).

The additive approach to calculating recognized revenue holds true for baseline software as well as any additional services a SaaS business might offer, such as support. While these additional offerings should be reflected as separate line items on financial statements, the revenue is parsed out over the life of the contract in the same way. Even costs to the customer such as implementation fees should be allotted across the term of the contract. That may seem counter-intuitive, as the service is provided to the customer upfront. However, new revenue recognition standards (ASC 606) that went into effect in recent years clarifies that this obligatory fee must be recognized as revenue in the same manner as subscriptions.

Many SaaS businesses have a tiered pricing model, offering higher subscription levels for more powerful versions of the software or offering a reduced price for longer contracts. In these businesses, an upgrade or downgrade in service needs to be reflected with an increased monthly recurring revenue and the difference in price should be added in the same daily prorated way that they would be for mid-month bookings.

Accounting for Churn

If your MRR is the growth engine that is keeping your SaaS business humming along, churn is the proverbial wrench. Whenever a customer ends their service, that loss should be accounted for with a decrease in the MRR via a metric called churn.

There are two ways to calculate churn: customer churn and revenue churn. Customer churn is the percentage of customers that end their subscription in a given amount of time, whereas revenue churn accounts for the revenue decrease from the lost customers. Losing a customer with low-level subscription will not have the same financial impact as losing a customer paying for the highest priced software to a different software company, or a lower tier package with your own. Tracking both is important for maintaining your financials and keeping a finger to the pulse of overall customer satisfaction, engagement, and product management

Managing Revenue Recognition in the SaaS Space

The easy error to make when running a SaaS business is allocating revenue for the full cost of the service at the time of the booking. However, doing this could result in the potentially egregious mistake of thinking you have more money than you do and spending money you haven’t actually earned. Any amount of money your company has received but hasn’t yet delivered the service for is deferred revenue. This income shows up on the balance sheet as a liability and should be treated as a reserve for churn. If a customer ends their contract early, the deferred revenue is money they are then owed.

SaaS is a popular and growing business model for a reason, SaaS companies often get paid large sums in advance of providing the service. With great reward also comes great risk, however, namely that you must manage your churn and plan your cash accordingly around these kinds of contract structures. You can’t reap the benefits without a solid legal and financial framework, and a good understanding of revenue as an accounting concept. Getting revenue recognition right is a critical part of that, and arguably one of the most important things to understand about your business.