Revenue recognition for SaaS contracts: ASC 606 for startups

01The five steps#

ASC 606 is set by the FASB and applies to private companies for annual periods beginning after December 15, 2018. A subscription to hosted software is normally a single obligation delivered evenly over the term, so revenue is recognized ratably, day by day or month by month. Everything else in this guide is about the pieces that sit around the subscription.

Every contract goes through the same five steps. For most early-stage SaaS contracts, steps one and four are quick and the judgment is in steps two and three. In order:

• Identify the contract: an agreement with enforceable rights and obligations, approved by both sides, where collection is probable.
• Identify the performance obligations: each distinct thing you promised, such as the subscription, a distinct implementation, premium support.
• Determine the transaction price: the consideration you expect, including estimates of variable amounts like usage and discounts.
• Allocate the price to each obligation in proportion to its standalone selling price.
• Recognize revenue as each obligation is satisfied: over time for a subscription, at a point or over time for services.

02Billed in advance: AR and deferred revenue#

A worked example. A customer signs a one-year contract starting October 1 for $36,000, invoiced in advance on Net 30. When the invoice is issued and payment is unconditionally due, debit accounts receivable $36,000 and credit deferred revenue $36,000. Nothing has been earned yet. When the cash arrives, debit cash $36,000 and credit accounts receivable $36,000; revenue still doesn’t move. At the end of each month, debit deferred revenue $3,000 and credit subscription revenue $3,000.

At December 31 the books show $9,000 recognized and $27,000 still deferred, whether or not the customer has paid. That is the distinction to keep: accounts receivable is what the customer owes you, deferred revenue is what you owe the customer in service. A large deferred balance with a large receivable behind it means you have billed far ahead of delivery and haven’t been paid yet; the cash and the revenue are both still to come.

03Implementation and setup fees#

The question is whether the implementation is distinct: could the customer benefit from it on its own or with resources readily available, and is it separately identifiable from the subscription? Setup work that only activates your platform, which no one else could do and which has no use without the subscription, usually is not distinct. Its fee becomes part of the subscription price and is recognized over the period the customer benefits, which is at least the contract term and can be longer if the fee gives the customer a material right to renew without paying it again.

A worked example. Add a $6,000 non-distinct onboarding fee to the $36,000 contract. The transaction price is $42,000, recognized over twelve months at $3,500 a month, rather than $6,000 in October. If, instead, the implementation were substantial configuration a consulting firm could do, it might be a separate obligation: allocate the total price to the two obligations by standalone selling price and recognize the implementation’s share as the work is done. Either answer is a policy you document once and apply to every contract like it.

04Usage and overages#

Usage fees are variable consideration. In general ASC 606 asks you to estimate variable amounts and constrain the estimate to what is unlikely to reverse, but for usage billed as it occurs there is usually a simpler answer. When the usage fee relates specifically to the service delivered in a period, it can be recognized in the period the usage happens, and an invoice that tracks the value delivered supports the same result.

A worked example. The customer used $1,200 of API calls above their plan in October, to be invoiced on November 5. At October 31, debit unbilled receivables (a contract asset or unbilled AR, depending on whether payment is conditional on anything but time) $1,200, and credit usage revenue $1,200. When the November invoice goes out, debit accounts receivable $1,200 and credit unbilled receivables $1,200. October’s revenue includes October’s usage, which is what a reader of the October P&L expects.

05Multi-year deals#

A three-year contract billed annually is usually three years of ratable revenue, with each year’s invoice creating a year of deferred revenue. Two things change when it is all paid up front. First, deferred revenue that won’t be earned within twelve months is presented as non-current on the balance sheet. Second, a payment made well over a year ahead of the service raises the question of a significant financing component: whether the customer is in effect lending you money. The practical expedient that lets you ignore financing applies only when the gap is a year or less; beyond it, the answer depends on why the customer paid early, and it needs a documented conclusion.

Discounts for longer commitments, ramped pricing that rises each year, and free months at the start all change the transaction price or its allocation across years. Ramped pricing for the same service, for example, generally means recognizing the total contract value evenly over the term, not following the invoices up the ramp.

06What to keep, and when it starts to matter#

For a startup on monthly self-serve plans, ASC 606 is barely visible. It matters from the first annual contract with an implementation fee, and it matters a great deal before a priced round or an audit, because a diligence team will rebuild revenue from your contracts. What makes that painless:

• A contract register: customer, start and end dates, total value, billing schedule, and each obligation.
• A written policy for implementation fees, usage, discounts and multi-year prepayments.
• A revenue schedule per contract, with the last month absorbing any rounding so it ends at exactly zero.
• A monthly tie-out: the deferred revenue schedule equals the balance sheet line, and unbilled receivables are cleared by the next invoice.