Understanding Revenue Recognition for Software and Service Companies
July 18, 2013 by Shyam Jha
I was recently speaking to a software company CEO who was excited about having signed a big multi-year contract with a customer. He mentioned that this contract would significantly increase his sales during the current year. I asked him about the kind of payment agreement his customer had signed. “It’s a software-as-a-service (SaaS) model. The customer will pay monthly fees.”
I told him that he would only be able to recognize the actual monthly payments made during the current fiscal year as revenue. He was surprised. “But we signed a three-year contract,” he said.
His contract reflected a booking, where he can reasonably expect the customer to pay the usage fees per month, provided the software performs as promised and the customer remains in good fiscal health. It did not, however, represent recognizable revenue.
There are four types of revenues a company needs to track:
- Booking: When a customer signs a contract, it is called a booking. So far, no cash has exchanged hands, and no service has been rendered.
- Deferred Revenue: You may collect a down payment on future services to be rendered at the time of signing the contract, but the revenue will be recognized over a period of time as the software gets used, or services delivered.
- Revenue: When you have delivered a service over a period, you may recognize that revenue at the end of the period. For example, if you sell an App that charges $1 monthly fee, your monthly revenue per customer is $1.
- Collection: Revenue for services rendered, but not yet received, is called collection. Typically, corporate clients pay 30 to 90 days after services are rendered. Therefore, you will have a revenue backlog, or collection (also known as accounts receivable), on your financial statement.
It is important to see the above four categories as a flow of revenue into your business. Not all bookings will turn into recognizable revenue, sometimes due to circumstances beyond your control. Your customer may terminate contract due to dissatisfaction with your services. Your customers may not have the ability to pay, due to circumstances beyond their control.
Revenue is the lifeblood of a business. You need to watch this flow carefully. The health of a business is often measured by their bookings to collections ratio. Investors also look for a Book to Bill ratio, i.e. the ratio of bookings to billings in a period. For example, if you had bookings of $110, and billed $100 to customers for products or services delivered in a quarter, your Book to Bill ratio is 1.1. Investors look for Book to Bill ratio above 1, since it implies a growing demand for your product or service.
Hardware businesses are known to “stuff the channels” during the last few weeks of a quarter or a fiscal year so they can show greater revenue recognition. It used to happen in software business as well, when software was sold in shrink-wrapped packages. But now most software is sold online either as a one-time download or as a SaaS subscription.
The Securities and Exchange Commission (SEC) regulates accounting rules for companies in the United States. They have established clear guidelines for revenue recognition that your CPA should be aware of. At a minimum, you should know the above four terms, and know how to describe your business in those terms.
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