Dear subscription billing companies, are you looking for significant investors? Then it is time to get serious about ASC 606 revenue recognition. It is a compliance measure that ensures subscription sales reporting and performance analysis is normalized across industries. So you and your investors know exactly where the business stands.
In this article:
- What is ASC 606?
- ASC 605 vs 606
- ASC 606 5 Steps
- How do I account for SaaS revenue?
- ASC 606 revenue recognition example
What Is ASC 606?
ASC 606, aka Topic 606, is a set of standards for recognizing revenue. These standards were created by the FASB for businesses that engage in contracts with customers. It is to standardize how to account for sales and revenue consistently across the business sector. ASC 606 revenue recognition provides a reporting framework that investors, banks, financial professionals, and owners can easily understand.
ASC 605 vs 606
ASC 605 preceded ASC 606. SaaS businesses in compliance with 605 switched over to ASC 606 revenue recognition. It was a collaboration between GAAP and IFRS standards to normalize revenue recognition across global markets. The effective date for switching to ASC 606, for public and private companies, started Dec 15, 2017, and Dec 15, 2019, respectively.
Who Must Follow The ASC 606 Revenue Recognition Standard?
ASC 606 rules guide revenue from contracts with customers. Many SaaS organizations lean on Topic 606 for reporting guidance. These rules structure all contracts in the same way so that each minor change to every contract can be visualized. The rules only apply to businesses performing the accrual-basis accounting method. For cash accounting, they do not affect you because this method only records income as it changes hands.
ASC 606 revenue from contracts with customers will affect:
- Multiple types of contracts like recurring billing or one-time payments
- Fluctuating expenses related to varied services like “seats” or “add-ons”
- Special discounts, upgrades, downgrades, cancellations, refunds, and fees
Subscription Accounting Treatment: Deferred Revenue Recognition Compliance
To understand ASC 606 for SaaS companies let’s explore deferred revenue. When someone signs up for a service they prepay for a service that will be performed at a later date. Deferred revenue is closely monitored by governing agencies because there is room for mishandling. How a company recognizes revenue, and the timing of their reporting needs to have a line of formality to maintain trust.
ASC revenue recognition standards give customers and businesses that formality. Contracts between provider and customer lay down what the deliverable from the business will be, how much a customer will owe, and a schedule for when payments are due. To recognize deferred revenue accurately, contracts are followed to the T.
ASC 606 5 Steps
Let’s take a deep dive into the ASC 606 5 steps. While they may seem straightforward you need to read the small script. As a subscription billing company, you could make thousands of accounting journal entries affecting your contracts. Following these steps for reporting revenue will help you avoid penalties and provide a more organized view of your profit.
1. Identify The Contract With The Customer
This is a detail of your business engagement with your customer; an agreement to enter into a mutually beneficial relationship. It is not necessary to have a sign-your-life-on-the-dotted-line situation, this first step simply encourages you to document your dealings. It makes accounting much easier and is verifiable proof for tasks like writing off bad debt expenses.
Most SaaS companies supply clients with a term of agreements and an invoice at signup. This is a traceable document with the obligations of the company, payment terms of the customer, and the conditions if the terms aren’t upheld. Just because you have a contract does not guarantee payment from the customer, so this outlines what each party is liable for when business goes sour.
2. Identify The Contract’s Performance Obligations
Here you must nail down your performance obligations to the customer.
Performance Obligation: the delivery of a distinct good or service
What is a distinct good or service?
It is a good or service that can be beneficially used by the customer, as an independent product. So its use cannot be tied to the purchase of another product or feature.
How do you judge whether a performance obligation is beneficial to the customer?
To prove that your product is beneficial you can show the history of prior sales of that specific product or its use in the market.
For Example: You sell an application subscription that measures the efficacy of digital marketing campaigns. The benefits are traceable via usage from previous customer purchases.
A good or service is NOT distinct when it requires another component for practical use.
For Example: You sell an add-on for your digital marketing application that connects to an expanded set of selling platforms. A customer cannot benefit from the add-on unless they have the base application, so these two items would be bundled together as one performance obligation.
Principal vs Agent Considerations
Topic 606 principal vs agent is an examination of third-party sales in SaaS revenue recognition. A third party would be anybody that provides goods or services to your customers. Evaluating whether you are a principal vs agent takes place when reviewing performance obligations in the ASC 5 steps.
The question you need to answer is:
How much control do you have over dispensing goods or services?
A principal delivers directly to the customer. Furthermore, principals are responsible for the goods or services obligation, they are liable for inventory, and have control over the price. Since they hold control over the goods or services, they should report gross revenue billed to the customer.
An agent will arrange for a third party to deliver goods or services to the customer. The agent relinquishes control of the disbursement of the goods or services to the third party. So they will only report net revenue earned from the customer, less subcontractor and/or supplier payments.
For Example: A homeowner’s insurance provider offers bundled car insurance but car insurance premiums are serviced by a third-party company.
3. Determine The Transaction Price
In this step of ASC 606 revenue recognition, you need to note the appropriate cost for your goods or services. Your transaction pricing needs to be linked to performance obligations of the contract. For subscription models, this is also where you note any additional pricing like add-ons, discounts, or customized offers.
Transparent contracts, with clearly labeled pricing, streamline ASC 606 revenue recognition. Since SaaS revenue is charged upfront, going back and changing the original transaction price, to fit the services that were eventually rendered, is rare. So you want to take a forward-thinking approach when valuing services. Utilize “if” and “when” situations to determine the best way to charge potential customer scenarios like upgrades, cancellations, etc.
4. Allocate The Transaction Price
Due to the nature of bundling services in SaaS, your expenses and fees are estimated into your subscription pricing. However, when you are in the throes of SaaS revenue recognition, you have to itemize the transaction price. The subscription accounting treatment allocates appropriate costs needed to meet your performance obligation.
Step 4 in the ASC 5 steps, is an assessment of the standalone selling price of all your contractual minutiae. While some of the services included in your subscriptions are too trivial to be considered distinct performance obligations, they are necessary to achieving customer satisfaction. So you have to put a price to these items as if it was an independent service. Your standalone selling price is something fair to the customer and comparable to market pricing.
For Example: You ensure data security for customer accounts on your digital marketing application. You need to estimate a justified fee for that piece of your subscription, and allocate it to the transaction price you initially charged.
Deferred Revenue Schedule
With Topic 606, you follow a timeline for meeting performance obligations and reporting income, called a deferred revenue schedule. Generally speaking, software billing models follow 2-3 packaged tiers, annually, semi-annually, or monthly. With revenue recognition deferred throughout the year according to software use. That being said, your subscription billing schedule can be organized in line with your business, as long as you follow the ASC 606 5 steps.
Note: Before ASC 606, SaaS companies divided payments up into two payment schedules—annually or biannually. This was because ASC 605 stated that a business could only recognize 6 months of revenue at once, per contract. Now, companies are given the freedom to recognize revenue on multiple dates throughout the year versus capitalizing revenue in chunks.
5. Recognize Revenue Once Services Or Goods Are Delivered
The 5th step in the ASC 5 steps, you may recognize revenue. This means there is a contract between you and the customer, the customer has paid, the performance obligations and the contractual timeline have been met, and you have accurately itemized the transaction price. Then income will move off your balance sheet accounts and into income statement accounts.
Correcting Revenue Recognition Errors
Mistakes happen. Perform a monthly check of your balance sheet and income statement. If you booked revenue too early, you need to start from scratch and recalculate earnings for all accounts. Improper revenue recognition will result in an overstated revenue account balance and an understated deferred income account balance. Even more, it will affect a variety of expense accounts.
In the event this happens you will need to make a reversal entry. You should always have an invoice to back up a reversal entry and a paper trail to prove the re-classified amounts. Get the reversal approved by a higher-up and log the change in your general ledger. This is proof of a correction, in case any external investigations come your way.
How Do I Account For Saas Revenue?
Knowing the ASC 5 steps is well and good, but how does it apply when you are accounting for SaaS revenue? When receiving prepayments, an entry will report the initial transaction subscription purchase. Then numerous entries follow to show money being incrementally recognized as revenue. We’ll describe this process using the ASC 606 revenue recognition example below:
ASC 606 Revenue Recognition Example
A subscription accounting firm offers services for $400/month with a year-long term. A new client opts for service and selects to prepay $4800 for the entire year. In addition to the monthly services, the client also signs up for historical bookkeeping to address a backlog of the previous quarter’s bookkeeping. The firm has discounted the normal rate of historical bookkeeping by 50%, for a total of $600. The accounting firm and the client agree on a total contract price of $5400.
Step 1 Identify The Contract
The first step in ASC 606 revenue recognition is to identify the contract. Below is the initial agreement made between the customer and the accounting firm.
|Monthly Recurring Services for 12 months
|$400 x 12 = $4800
|50 % Off Historical Bookkeeping
Step 2 Identify The Performance Obligations
The accounting firm will have two distinct performance obligations in this contract.
- Monthly Recurring Services
- Historical Bookkeeping
Monthly recurring services encompass bookkeeping and tax management. Financial statements will be delivered at the end of each month to mark the completion of services for the month. Historical bookkeeping is a one-time service to catch up on 3 months of past accounting. The final deliverable to mark this performance obligation, are financial statements for each month in the quarter, due 1 month from the date of the initial contract agreement.
Both services are considered distinct performance obligations. They can be performed independently of any other services offered by the accounting firm. Each is beneficial to the client because they are receiving year-round accounting maintenance, and catching up on unfinished bookkeeping for the previous quarter.
Step 3 Determine The Transaction Price
Since the client opted to pay upfront, a prepayment entry would be noted on the books. For the subscription revenue journal entry, you debit $5400 to your cash account, and credit $5400 to the deferred revenue account. Deferred revenue is where you hold the payment because it is not considered income yet! At this moment in time, it is considered a short-term liability on the balance sheet because you still owe services.
The prepayment represents the total value of the contract. When you recognize revenue you cannot recognize more than the transaction price. Unless there is a discontinuation or upgrade of services, these charges will not be modified.
Step 4 Allocate The Transaction Price
In accrual accounting, contract expenses need to be reported in the same period as revenue. For SaaS revenue recognition you will be itemizing any expenses, fees, and discounts relating to the contract. That means you need to estimate your standalone selling price for dependent items in the contract. As stated above your standalone selling price is fair to the customer and comparable to services rendered within the industry.
The accounting firm will report these items when recognizing revenue:
|Monthly Recurring Expenses
|($10) x 12 = ($120)
|($90) x 12 = ($1080)
|Historical Bookkeeping Expenses
|Historical Bookkeeping Discount
Step 5 Recognize Revenue And Expenses
One month has passed since the client initially signed up for services. The first month of accounting and historical bookkeeping for the previous quarter, is fulfilled. Now revenue and expenses can be recognized with some more subscription revenue journal entries!
For recurring monthly services, $300 will be recognized as revenue and $100 will be itemized to your various expense accounts. You debit the deferred revenue account $400, credit the sales account $300, credit your expense account $10, and credit payroll $90. This entry would occur each month for the duration of the contract.
Historical bookkeeping services have a separate entry because it is a distinct service. For one-time historical bookkeeping, $900 will be recognized as gross revenue, $300 will be itemized to your various expense accounts, and $600 will be noted as a discount.
To do this you debit the deferred revenue account $600, and credit the sales account $900. Wait, $900!? We need to account for the gross sales before the discount (remember that from step 1?), plus factor in expenses. Credits and debits must always match. Then, debit your sales discounts account $600, credit your expense account $30, and credit payroll $270.
Once ASC 606 revenue recognition takes place, the money is no longer a liability on the balance sheet. If your accounting system is set up properly you will see it added to revenue on the income statement.
ASC 606 Revenue Recognition
As a subscription-based software company, you need to follow ASC 606 standards. SaaS revenue recognition is highly nuanced so it is vital to have an accountant navigate your financial procedures. If you improperly recognize revenue, you risk misstating your income and will have to go through an arduous process to reclassify it. Having a solid subscription accounting treatment for revenue ensures accurate reporting to inform your company.