Features Pricing Blog
December 14, 2016
How Accurate Is Your Revenue Recognition?

SaaS presents a unique test for recognizing revenue.

Customers use your product but never really take delivery of it, and that usage could be once a month or one thousand times a month. Add in multiple different product offerings, enterprise solutions, and upgrades and getting it right seems like magic.

It's not magic, but it is one of the biggest challenges that any SaaS company will face. Though the finance industry has been trying to clarify and streamline the revenue recognition rules recently, there are still over 250 individual pieces of guidance that you have to understand to recognize revenue correctly.

That means there are 250 ways for it to go wrong.

Why recognize?

Cash accounting is easy. But it stops you making decisions.

Unless they have an accountant on the founding team, cash-based accounting is how most companies get started. This works when your business is small. If you can still do your books in your head each month then you can probably stay counting your cash.

But you don't want to be a small business. You want to grow, earn more, and offer more value to more people. For that, you need accrual accounting and the revenue recognition that comes with it.

Cash-based accounting only gives you a short term view of the world. Revenue recognition with this method is entirely based on cash transfers. There are no “accounts receivable” or “accounts payable.”

Intuitively, this sounds perfect. Either the cash is in your back account or it isn't, so you know where you stand in the world. But to be able to plan out the next month, quarter, year, or ten years, this is next to useless.

Counterintuitively, cash now can mean revenue later.

Revenue now vs. revenue later

Consider this typical business scenario: Your company completes a project for a client and sends an invoice for $100,000 worth of services.

Most businesses aren't going to send a guy with a briefcase full of Benjamins. Your invoice will be sent from your accounting department to theirs, where it will sit in a pile for a bit, before being shuttled around their system. Finally it will land on their CFO's desk, who will say yay or nay. Then it will go back to admin, who then sets up a bank transfer, introducing a whole new round of people and administration.

These things take time. If you are using cash-based accounting then for all that time your revenue is $0. This could be 30, 60, 90 days. With accrual accounting the moment that invoice was sent, the $100,000 could show up as revenue in your accounts. You can then use that revenue to plan out your 30, 60, or 90 days.

The difference comes down to this:

  • With cash-based accounting, you are effectively living paycheck to paycheck. No matter how much money you are owed, you can't see any of it on your books. You might know it's coming, but your books don't. No cash, no revenue. No revenue, no planning. No revenue, no business.

  • With accrual accounting and proper revenue recognition, you can do money management like an adult. Planning your businesses finances and thinking long-term.

But it is hard. Unless you have incredible guidance, you will make those 250 mistakes. Here are just some of the possible ways for you to screw this up.

Not understanding your performance obligations

If you don't understand your performance obligations then you don't understand what you are charging for.

In revenue recognition, a “performance obligation” is something you said you would do in the contract. When you're a one-size-fits-all, self-serve SaaS company, this isn't so much of an issue. You pretty much have only one performance obligation which is to give your customers access to your product.

But once the enterprise comes knocking with their promises of 10X revenues, pricing can become more complicated. You then get into the world of customized contracts, individual deliverables, and separate performance obligations.

Performance obligations for a SaaS company could be:

  • Giving your customer constant access to your product.

  • Supporting them via telephone, chat, or email.

  • Providing six months consulting services.

  • Helping them implement your product in the first three months.

New revenue recognition rules say that if performance obligations can be enjoyed alone, they need to be recognized individually.

Say your SaaS offers each of the above to its enterprise customers, with the following contract costs:

  • Product access: $12,000 per year

  • Support: $1,000 per year

  • Consulting: $6,000 total

  • Implementation: $3,000 total

Over the course of a year this customer is worth $22,000 in revenue. There are a few ways to recognize this revenue. You could recognize them all over the year on a straight-line basis:

straight line.pngEach is adding to your revenue each month. But this is wrong.

OK, two services are completed in less than 12 months. So let's recognize those over their own timeframes, three and six months:
separate.pngHere, implementation and consulting are recognized quicker, in three and siz months, respectively. Your revenue initially grows quicker as this revenue comes on the books, but then goes back to straight line growth half way through the year.

Wrong again.

Just because they are separate services doesn't mean they are distinct performance obligations. From these four services, there are only two performance obligations:

  • Performance obligation 1: Product, Support, Implementation. You can't use the implementation or the support separately from the product. There would be nothing to implement or support. Therefore these are bundled into one performance obligation and recognized over the length of the total contract.

  • Performance obligation 2: Consulting. This is separate from your product as it could be about their business or industry as a whole. Even if you don't offer it separately, it is distinct from usage with your product, so must be recognized independently over the length of its own usage. In this case six months. So the truth is:

obligations.pngConsulting is added in six months, the rest is straight line over the year.

This is pretty much as simple as it gets for revenue recognition, and still a lot of people would fall at this hurdle. Performance obligations are the base unit of the new revenue recognition rules, so you have to understand yours inside and out.

Being optimistic about when you can recognize your revenue

When you use accrual accounting, it can be tempting to get that revenue on your books as soon as possible. You can only recognize once you've satisfied your performance obligation (read: done what you said you'd do). This means that you have to deliver on expectations for your customers.

Some people set very low standards for that recognition bar. As forensic accountants Epstein & Nach put it: “Manipulation of reported revenue may be the most efficient single instrument in the would-be fraudster’s toolkit.

We're not accusing you of fraud. But there is a fine line between being optimistic about when you can recognize revenue and outright lying to partners and investors.

Just ask Autonomy. The UK company was bought by HP in 2011 for $11.1bn. Just one year later HP wrote down $8.8bn of that due to what they say were “serious accounting improprieties, disclosure failures, and outright misrepresentation at Autonomy.” Ouch.

Autonomy denies all of this. Autonomy sees their revenue recognition as above board, but it seems that the way they were recognizing revenue early was unclear to HP during the deal. The moral of this tale is that not being absolutely clear about when, where, and how you recognize your revenue can lead you into a world of pain.

Again, this is one of those things that sounds easy, but in reality can cause you all sorts of headaches. You have to factor in:

  • Dealing with downgrades, cancellations, and refunds.

  • Adding discounts to deals.

  • Acts of God.

That last one is serious. The possible inability of your customer to pay up, whether due to factors in or out of their control, has to be determined when recognizing revenue.

If you are not providing your customer what you said you would, you cannot recognize your revenue. If you do, and do so knowingly, it's fraud.

Not telling everyone about it

Revenue recognition is not just important for your decision-making, it's important for everyone involved in your company. Lenders, vendors, customers, and prospective and current customers all need to be able to rely on your revenue reports and predictions for their decision making. If you're not upfront with them, you can get into a world of pain.

Tesla has a better approach. In their 2013 Q1 shareholder letter, they said:

During Q1, we consistently produced 400 or more Model S vehicles per week, for a total of over 5,000 during the quarter. We recognized 4,900 vehicles as revenue, exceeding our initial Q1 guidance of 4,500, despite physically delivering a higher number of vehicles, as the standard for revenue recognition was extremely high. Even if a car was received, fully paid for and signed off as good by a customer, we did not recognize the revenue if the paperwork was incorrect.

Of course, this is a humblebrag. We could recognize more, but we're ahead anyway. Nevertheless, it shows that they are taking the performance obligations seriously. If the paperwork for the deliveries isn't good, they won't recognize the revenue until this obligation is met.

It's OK for you not to be as strict as Tesla. You can have different policies on revenue recognition to other companies. It is a lack of policies and transparency about those policies that really kill revenue recognition in SaaS.

Not tracking your cash flow

Right at the top we showed you why you should pick accrual over cash. But there is one thing that cash-based accounting is better for—cash flow.

As accrual accounting separates the idea of revenue and cash, you could potentially end up in a situation where you have a ton of revenue but little cash flow. This is unlikely in a SaaS business where you are billing monthly and then amortizing over a month or year, but it is something you need to watch.

For instance, in the scenario in the first section, under accrual accounting you got to recognize that $100,000 today. But you still don't have the cash. If you are dealing with other companies that run on accrual accounting and invoices then sure you can use that revenue on your own expenses. But at some point they are going to want the cash. Which means you have to have the cash.

Accrual and revenue recognition help you plan out the future. Just make sure you've got the cash to pay for it.

Doing it yourself

We covered this revenue recognition mistake a few weeks back. It is mistake #1.

Let's be frank. There are hundreds of individual guidelines, thousands of pages of rules to understand revenue recognition. CPAs spend their entire careers on this and can still screw up. You are not going to get it right in Excel.

Revenue recognition is no joke. This isn't an area of your company that you want to fuck about with. The best scenario with getting it wrong is screwing up your company. Get it wrong in a big way and you'll be explaining your bad math to the Department of Justice.

You need professionals and professional revenue recognition tools to do this properly for your company. Here we've barely scratched the surface of the tip of the iceberg on all the ways this can go wrong. This isn't financial advice. It's just a warning to the curious.

Do it, but do it right.

There is a reason that every single successful company uses accrual accounting and revenue recognition rules. It works. You can plan ahead and set your company on the path of growth better by using proper accounting.

But we cannot stress enough that this isn't something you can spend an hour a week on in Excel. It's great, but it's complicated. Do it, but do it right.

 

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