How do we recognize Revenue Recognition Challenges for SaaS businesses?
The growing trend and greater acceptance of SaaS business models all around the globe have changed the way that companies do business. The pace with which the SaaS model has crept into the business economy has been tremendous, and how it has revolutionized the economic climate is significant evidence of its worthiness.
However, the lingering effect of Covid-19 has negatively influenced the SaaS economic climate equally to other sectors. Many businesses have cut down on spending due to supply chain issues, high-interest rates, and inflation, leading them to prioritize cash preservation.
Furthermore, the current economic situation has also caused instability in the market, with businesses needing help to maintain their customer base. This has further led to increased competition, making it difficult for SaaS businesses to stay afloat.
SaaS businesses, specifically, are expected to encounter more challenges like downgrades, plan changes, or cancellations in the times to come. This makes SaaS businesses' struggle to recognize revenue even more critical.
Before moving ahead with the solutions to combat the revenue recognition challenges, let us first move ahead to know what revenue recognition is.
What is Revenue Recognition?
Revenue recognition is an accounting principle that dictates when and how revenue is recognized in accounting records and financial statements. Revenue is typically identified when it is realized or realizable and when it is earned.
Recognized revenue is the amount of cash or cash equivalents a company has received from customers in exchange for goods or services. It is considered to be earned when the company has fulfilled its obligations and provided the customer with the goods or services promised in the contract.
Ensuring accuracy in the financial statements means recognizing revenue at the right time. If revenue is recognized too early, it overstates the company's performance and leads to overstated profits. On the other hand, if revenue is realized too late, it understates the company's performance and leads to understated profits. This makes it a complex process that requires a thorough understanding of the relevant accounting standards and regulations.
Revenue Recognition ASC 606 Challenges
The Financial Accounting Standards Board (FASB) has created ASC 606, or Accounting Standards Codification (ASC) 606, to guide companies on properly recognizing and reporting their revenues.
ASC 606 provides a five-step approach for companies to follow when recognizing revenues. The steps involve:
- Identifying the contract with a customer
- Identifying performance obligations
- Determining the transaction price
- Allocating the transaction price to each performance obligation
- Recognizing the revenue when or as each performance obligation is completed.
Despite the straightforward guidelines of ASC 606, it can be challenging for companies to recognize their revenues in compliance with the new standard. Companies often face several challenges in implementing ASC 606, such as determining the appropriate time for revenue recognition and accurately measuring the transaction price.
Revenue Recognition Challenges Business Encounter
Despite the significant benefits in its favor, the SaaS business model brings some complications in accurately encountering and assessing revenue recognition. It is an important and complicated accounting principle that affects businesses of all sizes.
The changing accounting standards and regulations have made recognizing revenue challenging and complex. As a result, businesses of all sizes must be aware of the revenue recognition challenges to ensure accurate and timely financial reports.
Below are a few of the SaaS revenue recognition challenges your business can encounter, which can inhibit your growth rate.
Pricing Model Flexibility
SaaS products, despite their simplicity, are intricate by nature. As a result, flexibility with different plans and pricing has become a significant challenge business face in revenue recognition.
Because of the multiple services offered by SaaS-based businesses and the possibility of a change in contracts, a tool is required to bundle each consumer's information separately. Manual accounting of the whole system is quite tricky and prone to errors.
What if someday, your customer decides to upgrade, downgrade, or even wants to cancel their subscription midway through the contract?
This makes it one of the notable revenue recognition challenges that would create chaos in recognizing the revenue, as you can only calculate revenue after the service is provided.
In the case of a canceled subscription and a change in plans, it is essential to recognize revenue correctly. The most common way of recognizing revenue in this scenario is to record the revenue at the time of purchase. A refund is typically issued to the customer when the subscription is canceled. This refund should be recorded as a reduction in revenue.
In cases where the refund is not issued until after the cancellation is completed, the revenue should be recorded when the subscription was initially purchased. This is because the customer has already received the benefit of the subscription at that time. It is important to note that the refund should be recorded in the same period as the initial sale rather than in a separate period. This would misrepresent the actual revenue for the period.
Usage-Based Pricing
With the expected economic downturn, customer behavior and expectations are changing. People prefer to pay for the services they utilize.
Under traditional pricing models, businesses recognize revenue when customers purchase the product or service. With UBP, revenue recognition is more complex because customers may use the product or service for a period rather than making a one-time purchase. As a result, businesses must recognize revenue based on usage, which can take time to track.
Payment Failures
Payment failures constitute a significant issue for businesses, as they can have broad implications. Therefore, it is essential for companies to understand the potential complications that may arise from payment failures and to put measures in place to mitigate them.
This includes developing a system to track payments accurately, having the plan to address payment failures, and being aware of the accounting and compliance standards associated with revenue recognition.
Companies must adhere to specific standards for revenue recognition, such as GAAP, and failure to meet these standards results in penalties and other sanctions.
Payment failures lead to delayed payments to creditors, which create liquidity issues and cause financial distress, complicating forecasting future revenue. It can be easier to accurately predict future sales with an accurate understanding of the amount of money coming in.
Scalability
Scalability has become an essential factor that complicates revenue recognition because it impacts how and when the revenue should be recognized. This is especially true when subscription-based businesses transition from survival to thriving mode. This expansion necessitates giving accurate financial accounts the same importance as your products.
Inculcate Automation At The Core Of Your Business
Automation is an invaluable tool for businesses when it comes to combating revenue recognition challenges. Automation helps companies to streamline their operations and improve the accuracy of their financial reporting and decision-making.
Revenue recognition becomes quicker and more accurate by introducing your business to automation, reducing the risk of errors and miscalculations.
Automation helps businesses quickly and accurately capture data from various sources, such as sales transactions, invoices, contracts, and other documents. This data is then used to calculate and report on the total revenue generated by a business.
Automation helps businesses recognize revenue following Generally Accepted Accounting Principles (GAAP), an essential consideration for financial reporting while assisting businesses to streamline their processes and reducing the manual effort required for revenue.