Software and SaaS Accounting: Revenue and Costs

Introduction

ServiceNow, which sells workflow software to large companies by subscription, recognized $13.3 billion of revenue in 2025, 97% of it from subscriptions. At the end of the year, it had already been paid or invoiced for $8.4 billion of revenue it had not yet earned, carried as deferred revenue, and had $28.2 billion of contracted revenue still to recognize in total, 46% of it within the next twelve months. Its operating income under generally accepted accounting principles (GAAP) was $1.8 billion; excluding $2.0 billion of stock-based compensation and some other items, it reported non-GAAP operating income of $4.1 billion. Its free cash flow was $4.6 billion, according to its 2025 annual report.

Each of those figures tells a different part of the story, and a software company cannot be understood from any one of them. Revenue lags the contracts that produce it, cash arrives ahead of revenue, some selling costs are capitalized while most development costs are expensed, and a large part of employee pay is in stock. Reading the statements well means knowing how those pieces fit together.

Under the revenue standard, Accounting Standards Codification (ASC) Topic 606, a software-as-a-service subscription is a service delivered continuously, so its revenue is recognized evenly over the contract term, as explained in the ASC 606 five-step model. Customers, however, typically pay annually in advance. The gap between the two is deferred revenue, a contract liability that rises when the company bills and falls as it delivers. ServiceNow's current deferred revenue rose from $6.8 billion to $8.3 billion during 2025.

Term licenses for software that customers install themselves follow a different pattern: the license portion is usually recognized when the software is made available, with support recognized over time. A company moving customers from on-premise licenses to cloud subscriptions therefore sees reported revenue grow more slowly during the transition, even if contract values are rising, because revenue that used to arrive up front is now spread over the term, the pattern discussed in the technology, media and telecom (TMT) guide's article on the on-premise to cloud transition.

Usage-Based Pricing

A growing share of software and cloud revenue is priced on consumption rather than seats or fixed subscriptions: customers commit to a level of spending, or simply pay for what they use, and revenue is recognized as the service is consumed. Revenue then depends on customers' activity in the period, not on the passage of time, so it can accelerate or slow quickly, and contracted commitments may run ahead of or behind actual use. For these businesses, remaining performance obligations say less about near-term revenue, and the drivers worth tracking are customer consumption trends and the share of revenue above committed minimums.

Remaining Performance Obligations and Billings

Two measures look through the lag. Remaining performance obligations (RPO) are the total contracted revenue not yet recognized, including deferred revenue and amounts not yet invoiced on non-cancellable contracts; the current portion, revenue expected within twelve months, is often the better indicator of near-term growth. ServiceNow's RPO grew 27% and its current RPO 25% in 2025, ahead of its 21% revenue growth. Calculated billings, revenue plus the change in deferred revenue, approximate what the company invoiced in the period:

Remaining performance obligations

The transaction price of contracts with customers allocated to performance obligations not yet satisfied, including deferred revenue and non-cancellable amounts to be invoiced and recognized in future periods. Companies disclose the total and the portion expected to be recognized within a stated period, usually twelve months.

Billings are noisy. They move with the timing and length of invoicing, a shift from annual to multi-year billing raises them temporarily, and acquired deferred revenue adds to them without any new sales. They are a useful cross-check on growth, not a substitute for RPO, and the balances behind them are described in contract liabilities and contract assets.

Commissions

Sales commissions paid to win a contract are incremental costs of obtaining a contract, so ASC 340-40 requires them to be capitalized when the company expects to recover them and amortized over the period of benefit, which for software usually includes expected renewals. A company may expense them as incurred only when that amortization period would be one year or less, the practical expedient described in PwC's guide to contract costs. ServiceNow amortizes commissions on new and expansion contracts over five years. In 2025, it capitalized $758 million of commissions and amortized $621 million, and carried $1.7 billion of deferred commissions on its balance sheet. When a company grows quickly, capitalization exceeds amortization and reported sales and marketing expense is lower than the cash paid; the reverse happens when new commission spending falls below the amortization of earlier years' contracts, as it can when bookings stall.

Development Costs

Most software development is expensed as research and development. Costs of software sold to customers are capitalized under ASC 985-20 only after technological feasibility is established, which for most companies happens so late that little is capitalized. Costs of internal-use software, including the platforms that deliver cloud services, fall under ASC 350-40 and are capitalized during the application development stage, once management has committed to funding the project and its completion is probable. The Financial Accounting Standards Board's (FASB) 2025 update to these rules, Accounting Standards Update (ASU) 2025-06, explained in Deloitte's summary of the new software cost guidance, removes the old project stages and requires capitalization to wait until significant development uncertainty is resolved, from annual periods beginning after December 15, 2027. The broader principles are covered in capitalizing vs expensing costs.

Cost of Revenue and Hosting

Cost of subscription revenue includes the cost of hosting the service, in a company's own data centers or on public cloud providers, customer support, and the amortization of capitalized internal-use software and acquired technology. It is the main driver of subscription gross margin. ServiceNow's cost of subscription revenue rose 32% in 2025, to $2.6 billion, faster than its 21% subscription revenue growth, which took its subscription gross margin from 82% to 80%. For software companies adding artificial intelligence (AI) features that require heavy computing, this line has become one of the most closely watched in the income statement.

Stock-Based Compensation

Software companies pay a large share of compensation in equity. ServiceNow's $2.0 billion of stock-based compensation equaled about 15% of its revenue, more than its GAAP operating income. Companies exclude it from non-GAAP margins, and those adjusted margins, 31% for ServiceNow against 14% under GAAP, are the figures most often quoted. The cost is real, paid in dilution, which is why bankers either deduct it or subtract the cash spent on buybacks to offset dilution, the treatment explained in stock-based compensation accounting.

Bankers analyze software companies on a set of operating metrics alongside the statements. Annual recurring revenue (ARR) measures the run-rate of subscriptions; net revenue retention measures how much existing customers expand or shrink their spending; gross margin on subscriptions shows the cost of hosting and support; and the rule of 40, growth plus free cash flow or earnings before interest, taxes, depreciation and amortization (EBITDA) margin, balances growth against profitability. Several of these are company-defined, as the TMT guide's article on ARR and recurring revenue metrics explains, so comparisons need consistent definitions. Net revenue retention is the single best indicator of product strength for many investors: a rate above 100% means the existing customer base grows on its own, before any new customers, as described in the TMT guide's article on net revenue retention.

Valuation follows the same logic. Growing software companies are often valued on multiples of revenue or of next year's revenue, because their earnings are depressed by sales and development spending that builds future revenue; more mature companies trade on free cash flow and earnings, with the treatment of stock-based compensation making a large difference. For acquisitions, purchase accounting measures the target's deferred revenue as if the buyer had written the contracts itself, a rule introduced by ASU 2021-08 that ended the old practice of writing acquired deferred revenue down to fair value. It also values the target's technology and customer relationships as intangible assets, as described in purchase price allocation, and the resulting amortization is one of the items excluded from non-GAAP figures.