SaaS revenue recognition: ASC 606 for SaaS companies

In SaaS, subscriptions-based services are super common and revenue streams can be as unpredictable as the weather. This is why accurate revenue recognition is the bedrock of financial stability for many SaaS companies.

Enter ASC 606, the revenue recognition standard set forth by the Financial Accounting Standard Board (FASB), which applies to most businesses with customer contracts.

In this article, we’ll explain what compliance with ASC 606 for SaaS companies actually means. We’ll also cover the following topics:

• The five steps required for recognizing revenue under ASC 606
• Common pitfalls SaaS orgs face with ASC 606 compliance
• Tips for implementing ASC 606 in SaaS businesses
• Why revenue forecasting is so important
• How Orb solves the common pitfalls of ASC 606 compliance

Let’s start with a simple yet important question:

What is ASC 606 for SaaS companies?

ASC 606 outlines the principles for recognizing revenue from customer contracts. It is a software revenue recognition standard that focuses on when control of goods or services is transferred to the customer. 

Why is it so important?

ASC 606 is the financial compass guiding your SaaS business through the sometimes choppy waters of revenue reporting. It helps guarantee that your financial statements accurately reflect your company's performance. The ASC 606 is crucial for a multitude of reasons:

• Investor confidence: Investors want to see a clear and consistent picture of your revenue. ASC 606 provides transparency, helping to build trust and attract potential investment.
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• Audit readiness: No one wants a surprise during an audit. By adhering to ASC 606, you can ensure your financial statements are audit-ready. This preparation minimizes headaches and potential issues down the line.
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• Strategic decision-making: Accurate revenue recognition lets you make informed decisions about your business. You'll better understand your true profitability. This knowledge can then guide future pricing strategies and product developments. 

The 5-step model for recognizing revenue under ASC 606

ASC 606 provides a five-step framework to guide SaaS companies through the process of revenue recognition. Let's break down each step and see how it plays out in SaaS:

1. Identify the contract with the customer

This first step is about pinpointing the agreement between you and your customer. This contract will create enforceable rights and obligations for both parties.

Think of that standard software subscription agreement your customers sign. It outlines the services you'll provide (access to your software), the price they'll pay, and the terms of the agreement. That's your contract.

2. Spot the performance obligations in the contract

Next, you need to dissect the contract to identify the specific promises you've made to your customer. These would be services you're obligated to deliver.

Your subscription may include access to the software and ongoing customer support. Both of these represent a separate performance obligation.

3. Determine the transaction price

This step is about figuring out how much you expect to be paid for fulfilling those promises. You need to consider discounts, variable fees, and even the time value of money if there's a financing component involved.

For example, let's say a customer signs up for a $1,000/month subscription but gets a 10% discount for paying annually upfront. Your transaction price is no longer $12,000; it's now $10,800 with the discount.

4. Allocate the transaction price

SaaS companies often have multiple performance obligations. This means you need to divvy up the transaction price among them based on their standalone selling prices. It's like slicing a pie — each slice represents the value of a specific obligation.

Look at the previous example of that subscription with software access, support, and training. You'd need to figure out what each of those would cost if sold separately and then allocate the $10,800 accordingly.

5. Recognize revenue

The final step is where the rubber meets the road. You recognize revenue as you fulfill each performance obligation. Revenue recognition can happen at a single point in time (like when you deliver a software license) or over time (like with ongoing support services).

For the software access, you'd likely recognize revenue monthly as the customer uses the service. Revenue for the one-time training session will be recognized once the training is complete.

Key challenges SaaS companies face with ASC 606 compliance

Let's explore some of the common challenges when it comes to software as a service revenue recognition:

Untangling the performance obligations

Identifying distinct performance obligations can be a real head-scratcher. Is that ongoing customer support a separate obligation, or is it intertwined with the software access? What about those bundled offerings — are they distinct or part of a bigger package? 

These questions require careful consideration and judgment. We’ll explain the role of billing software platforms and revenue recognition software in a later section. 

The variable conundrum

SaaS pricing is anything but static since discounts, promotions, and usage-based fees are the norm. These variable considerations can complicate revenue recognition. The challenge is that you need to estimate the transaction price continuously and potentially adjust it over time. 

That’s without even getting into contract modifications. Changes such as upgrades and downgrades can throw a wrench in your carefully laid plans.

The changing nature of SaaS solutions

SaaS products are always evolving, with frequent updates, add-ons, and upgrades. This evolution is great for customers, but it can make ASC 606 compliance even trickier.

The challenge comes when changes create new performance obligations or update existing ones. You’ll need to analyze these changes to remain compliant with ASC 606 for SaaS companies.

How to implement ASC 606 in your SaaS business

Implementing ASC 606 in your SaaS business can feel like navigating a maze, but with the right approach, you can emerge victorious. The following key tips will help you on your journey.

Tip 1: Identify contracts correctly

The foundation of accurate revenue recognition lies in clear contracts, so we recommend you:

• Scrutinize your contracts: Make sure your contracts with customers are crystal clear. They should explicitly define all performance obligations. Include details like the services provided, the duration of the contract, and the payment schedule.
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• Leave no ambiguity: Eliminate any ambiguity in your contracts. Especially those that could lead to different interpretations of performance obligations. The clearer the contracts are, the easier it will be to apply ASC 606 for SaaS companies accurately.

Tip 2: Determine transaction prices accurately

SaaS pricing models are often dynamic. This means accuracy is vital when calculating the transaction price. Our three key tips on this point are:

• Factor in all variables: Don't just focus on the base price. Consider all variable considerations that could affect the final transaction price. Think discounts, credits, and performance bonuses.
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• Estimate with precision: If you have variable considerations that are difficult to predict, use reasonable estimation methods to determine the transaction price. We will discuss more tools to do this in a later section. 
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• Stay updated: Keep track of any changes in your pricing models or contracts. Pay special attention to those that could impact the transaction price and adjust accordingly.

Tip 3: Track performance obligations 

With recurring subscription models, tracking when each performance obligation is met is essential. Here are some tips to do so:

• Create a system: Establish a system to track the fulfillment of each performance obligation, especially in recurring subscription models. You could use a CRM system, an ERP system, or a custom-built solution.
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• Monitor closely: Regularly monitor your performance obligations. Though it may seem obvious, this step helps guarantee revenue is recognized accurately and timely.
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• Address changes: Be prepared to adjust your tracking system as your business evolves and your obligations change. SaaS products often change, so it’s important to be on top of this when scaling up, for instance. 

Tip 4: Make reporting easier for yourself 

Efficient reporting translates into compliance with ASC 606 for SaaS companies. Here are some tips to help you simplify the reporting process: 

• Embrace automation: Use automation tools and processes to streamline your revenue recognition reporting. This type of assistance can help you save valuable time and reduce errors. 
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• Choose the right tools: Select tools that are specifically designed for SaaS businesses. Choose those that can handle the complexities of your revenue recognition process beyond just the basic revenue recognition software. 
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• Standardize your reports: Develop standardized reporting templates to guarantee consistency and accuracy in your financial statements.

Why accurate revenue forecasting under ASC 606 is so important

In SaaS, subscriptions and recurring revenue models are common. This is why accurate revenue forecasting is paramount. However, ASC 606 adds another layer of complexity to this task, particularly when it comes to deferred revenue.  

With upfront payments for services delivered over time being the norm, SaaS organizations often deal with deferred revenue.  

ASC 606 for SaaS companies mandates recognizing this revenue as the performance obligations are fulfilled. This is completely different than going the traditional route which is to do it at the time of payment. 

The takeaway? Revenue forecasts need to reflect this gradual recognition. It should take into account the potential contract changes and cancellations discussed earlier. All variables that could impact the timing and amount of revenue recognized should be considered too.  

Failure to comply with ASC 606 can have dire consequences. Financial misstatements can erode investor confidence and lead to issues in raising capital or even legal action. Regulatory penalties can also be imposed, further damaging your company's bottom line.

How Orb solves ASC 606 compliance challenges for SaaS companies

Orb is a done-for-you billing solution. It helps SaaS companies overcome the intrinsic challenges of ASC 606 compliance.

 It simplifies the process, and here’s how:

• Real-time tracking of performance obligations: Orb's robust metering infrastructure captures granular usage data. This feature also enables the identification and tracking of performance obligations. Orb helps make sure that revenue is recognized precisely when the service is rendered. This way, you’re always aligning perfectly with ASC 606 guidelines.  
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• Automate SaaS revenue recognition: Orb’s billing engine and its data aggregation features do the heavy lifting. They automate complex revenue recognition calculations quickly. This reduces the risk of errors. The result is continuous compliance with ASC 606 even as your SaaS business grows and evolves.  
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• Support flexible billing and changes in contracts: Orb's plan versioning and price change management features let you adapt your pricing and offerings, all without the fear of disrupting your financial reporting. It doesn’t matter if it’s upgrades, downgrades, discounts, or new product launches. Orb handles these contract changes gracefully while maintaining ASC 606 compliance.
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• Customizable reporting tools: Orb has detailed reporting capabilities. This is especially useful thanks to its integrations to popular accounting systems.

You can create complete reports that meet ASC 606 standards. These reports provide a clear view of your financial performance. They are ready-made for scrutiny by investors or auditors. It instills confidence in your company's financial health.

Take your next steps with the help of Orb

In this guide, we explained the role of revenue recognition and the importance of compliance with ASC 606 for SaaS companies. 

We’ve also shown the role of Orb as a solution for making ASC 606 compliance easier. 

Orb is a flexible billing engine for hybrid and usage-based pricing built for developers and finance teams. Orb ingests product usage data at a massive scale, speeds up new product launches, and provides detailed financial reporting.

Fortunately, Orb’s impact is something you can corroborate yourself. Try out Orb’s free demo and explore the possibilities of a done-for-you billing platform.