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SaaS Accounting Basics

If you are a SaaS business, you must read this article to know:

  • What are SaaS Accounting Basics?
  • How is SaaS Accounting Different From Traditional Accounting?
  • What are The Different Types of SaaS Accounting?

SaaS products and services have become indispensable given the speedy transition to digitization. With more and more SaaS startups rolling out SaaS offerings, there’s no way we can see the wave slowing down. And with the growing SaaS offerings and their demand are the key changes in SaaS accounting. For instance, the Accounting Standards Codification 606 or ASC 606

Therefore, it is important for both the accounting and finance teams to understand SaaS accounting for accurate forecasting and financial reporting. Given the subscription-based model of SaaS companies, SaaS accounting is different and at the same time challenging in certain aspects. 

Additionally, irrespective of whether you are a startup or a small and medium-sized SaaS business, it is important to have your SaaS books of accounts in place. 

We’ve come up with this SaaS accounting guide that will help you know the key SaaS accounting basics and concepts you and your accounting teams must know. 

What is SaaS Accounting?

SaaS accounting is basically accounting for cloud-based software or service providers in which these software providers host the application. Accordingly, there is no need for the software to be installed in the local systems of the customers. Customers can access the SaaS applications digitally across various devices like desktops, tablets, mobile devices, etc. 

Further, SaaS accounting is different and has certain specific requirements which must be complied with. For instance, SaaS businesses with subscription-based business models need to comply with ASC 606. Whereas, non-profit SaaS companies need to keep records of grants received. 

SaaS Accounting Basics: How is SaaS Accounting Different? 

SaaS accounting is different from the accounting for traditional licensed software. The major differences lie in cost and revenue recognition

Revenue in SaaS Vs Traditional Software Company

In the case of a traditional software company, the sale of a software license is taken as product sales. However, a sale of a SaaS application is taken as a sale of service which will be rendered by the SaaS company over a period of time. 

Likewise, where a traditional software company gives the right to the customer to use the software on its local devices for the period for which the license is purchased. The SaaS provider, on the other hand, hosts the application on its own servers and the customers can use this hosted service. However, the customers do not get the software itself that they can use on their own. 

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Accordingly, since SaaS companies provide hosted service to their customers, it works on a subscription-based model. Accordingly, SaaS companies receive recurring payments over a period of time of the subscription, which is typically a year. Thus, a SaaS company cannot recognize the whole of the revenue that it generates at the time a customer buys an annual subscription to the SaaS application. 

It can only recognize the portion of the revenue in a given period that represents the worth of service rendered in the given period.

This is unlike the traditional software companies that treat sales of software licenses as a product. Thus, such companies immediately recognize the payment received from software sales as revenue in their books of accounts. 

Invoice in SaaS vs Traditional Software Company 

The invoice of a SaaS provider includes subscription fees. The fees cover everything from the cost of using the SaaS service, to maintenance, and customer support. 

Whereas, the invoice of a traditional software company includes the license cost, installation cost, support and maintenance cost, and customization costs separately. 

Apart from this, SaaS companies have complicated cash flows due to the subscription-based model. Further, they have a lower COGS which only consists of the hosting cost, merchandise fees, and support cost. As a result, SaaS companies enjoy higher gross margins, which typically range between 80-90%.

Types of SaaS Accounting: Cash Vs Accrual Method of Accounting 

As per IRS, companies need to adopt accounting methods to account for income and expenses in their books of accounts. Accounting methods are rules that govern the way income and expenses are to be reported into your books of accounts for tax returns. 

Accordingly, the accounting method determines the method of accounting followed by a business together with accounting treatment for various transactions. 

One thing that companies need to keep in mind is that they must follow the same accounting method year after year. This is because consistency in accounting methods will help companies to know accurately how much income they have generated period after period. 

Typically, there are two methods of accountancy that you can adopt as a SaaS company. 

1. Cash Method 

Under cash method accounting, the income is recognized at the time the cash is received for the product or service sold. Likewise, the expenses are recorded at the time they are incurred. Accordingly, you cannot record or account for items like bills receivable, bills payable, expenses paid in advance. 

Individual and small businesses can go for a cash-basis of accounting. However, IRS prohibits partnerships or corporations with more than $27 million of average annual gross receipts for the past three tax years to adopt the cash-basis of accounting. Such companies are required to follow the accrual method of accounting. 

Advantages of Cash Method

  • It is simple and easy to implement
  • Suitable for individuals and small companies as they do not have to follow complex accounting methods and treatments
  • It helps in determining the cahs in hand balance accurately at the end of the accounting period

Disadvantages of Cash Method

  • It can reveal a false or inaccurate picture of the financial health of the company. This is because there may be times when contracts may last for more than one accounting period. Since the revenue is recognized at the time when the cash is actually received, the company may not be able to record such revenue in the accounting period. However, it may record expenses incurred during the accounting period for such a contract. As a result, companies’ books of account may show huge losses in period and exaggerated profits during the other. 
  • Also, it is difficult for such companies to raise funds due to the inaccuracy in the financial statements. 

2. Accrual Method 

Under the accrual method of accounting, income and expenses are recorded in the accounting period in which they are earned or incurred. This method of accounting goes by the matching principle of accounting that states income and expenses must be recognized in the accounting period in which they are earned or incurred. 

That is, revenues must be matched with the expenses in the accounting period in which the accounting transaction takes place and not when the cash is received or paid. 

As per IRS, partnerships, and corporations whose average annual gross receipts in the previous three years exceed $27 million are required to adopt the accrual method of accounting. 

Advantages of Accrual Method

  • Unlike the cash basis of accounting, the accrual accounting method gives an accurate view of your company’s financial condition. This is because you record income and expenses at the time they accrue or are incurred. 
  • You can record and account for complex transactions like credit sales and purchases. When it comes to SaaS companies, they can record subscription fees received for which they are yet to provide services over the subscription period. 
  • Likewise, the accrual method of accounting gives you a clear view of future cash inflows and outflows. This helps you to see how you can manage your resources and keep enough for future periods. 

Disadvantages of Accrual Method

  • This method is expensive. 
  • Individuals and small companies find it difficult to implement this due to its complexity. 

Revenue Recognition For SaaS Businesses

GAAP has revenue recognition as one of its core principles. As per this principle, a business entity must recognize the revenue that the entity expects to receive for the goods or services that it promises to deliver to its customers. Accordingly, the amount recognized as revenue must reveal the transfer of promised goods and services to customers and reflect the amount that the entity expects to receive in return for such goods and services. 

However, both FASB and IASB issued a joint standard on revenue recognition of revenue from contracts with customers in May 2014. This is called ASC 606. Thus, companies that get into contracts with customers for the delivery of goods and services in return for payment were required to abide by these changes in the standard. 

Before discussing the five-step process rolled out under ASC 606 for revenue recognition, lets’ have a look at what is deferred revenue. 

Deferred Revenue

Deferred Revenue refers to the revenue that a SaaS business generates before delivering the product or service to the customer. It refers to the payment that customers make to a SaaS business before such a business delivers the product or service to them.

Such a payment is showcased as a liability in the balance sheet of a SaaS company. The liability so created represents the obligation of the SaaS company to deliver the product or service to the customer at some point in the future. This liability is called Deferred Revenue. 

Since SaaS companies are based on the subscription model, they receive the subscription fee for the entire period of subscription, typically one year. The payment received as a subscription fee increases the cash balance by the subscription amount but creates a liability in the form of deferred revenue by the same amount. Eventually, the deferred account is debited or reduced with a monthly fee representing the service provided for that month, and the sales or revenue account is credited with the same amount. 

Say, a customer buys the annual subscription worth $120 of a SaaS application in a given month. 

Now, the SaaS company debits the cash account by $120 and credits the deferred revenue account by $120 because $120 is a liability for the SaaS company at the time it receives it. This is because it hasn’t delivered the service for which it has received the payment. 

Over a period of the annual subscription, the SaaS company debits the deferred revenue account with $10 per month and credits the revenue or sales account with $10 for that month. 

SaaS Revenue Recognition ASC 606

Both FASB and IASB came together and rolled out the updated ASC 606 standard for revenue recognition. This standard includes revenue recognition in the case of entities that enter into contracts with customers to deliver goods and services in lieu of payment. 

To achieve the main principle of revenue recognition by GAAP as stated above, entities must adopt the following 5-step model. This has gotten the SaaS companies to get rid of the complexity and confusion that existed in SaaS accounting as a result of undefined accounting practices. 

1. Identify Contract With the Customer

This defines the parameters that an entity needs to ensure it meets to establish a contract with the customer. A contract is an agreement between two or more parties that establishes rights and obligations that are binding on the parties to the contract. 

2. Identify the Performance Obligations in the Contract

This spells out the performance obligations or goods or services that the business entity promises to deliver to the customer. The entity can promise to deliver distinct goods which must be called out separately in the contract. 

3. Determine the Transaction Price 

Here, the entity needs to define the transaction price taking into account various considerations as defined in ASC 606. 

4. Allocate the Transaction Price 

In this step, the business entity needs to allocate the transaction price to various performance obligations as spelled out in step 2.  

5. Recognize the Revenue When the Performance Obligation is Met 

Here, the business entity needs to determine the time when it will recognize the revenue. This would depend on when the control of goods or services is transferred to the customer. 

GAAP Accounting for Software as a Service 

The accounting standards govern the manner in which financial accounting and reporting must be undertaken by business entities. FASB regulated Generally Accepted Accounting Principles (GAAP) spell out the accounting standards so that: 

  • there is no discrepancy in the way business entities across industries treat similar accounting transactions so as to bring transparency and consistency
  • various stakeholders can easily understand and compare the financial statements of various business entities. 

It is highly recommended to follow the GAAP guidelines for maintaining books of accounts. This applies even to SaaS startups. Following the GAAP guidelines and accounting principles will make your books consistent, compliant, and comparable. 

Thus, as a SaaS business, you will be able to undertake financial analysis and forecasting efficiently since your accounting books reveal accurate information. 

Moreover, various stakeholders like investors will get accurate information about company financials which will help them in making investment decisions easily. Also, SaaS companies with proper books of accounts as per GAAP will be able to raise funds without any challenges. 

Key SaaS Metrics and Financial Reports 

A SaaS business must evaluate its revenue by tracking revenue drivers like bookings, calculated billings, and recurring revenue. Similarly, there are various SaaS key performance indicators that SaaS companies must track for measuring their growth and overall performance. 

Bookings

Bookings in the case of a SaaS business refer to the sum of all the closed deals in a particular year. In case a SaaS business tracks financials on a monthly basis, then booking refers to the sum of all the closed deals in a given month. Note that Bookings is a contracted value. Thus, it showcases the deals closed with different prices and durations.

Calculated Billings

Calculated Billings refers to the sum of revenue generated during a period (i.e. a quarter) and the change in the deferred revenue from the prior quarter to the current quarter. Investors track calculated billings rather than revenue as they believe it is a better forward-looking metric with regards to the health of a SaaS business.

For instance, if the bookings of a SaaS business increase either through renewals, upsells, or new business, it will lead to an increase in billings as well.

Thus, as per investors, a SaaS business can showcase a more stable revenue over a period of time. This is because a SaaS business can adjust the Billings Backlog from the total bookings and showcase a more healthy business.

Note that customers can make payment against SaaS billings in advance or over the life of the contract. 

Recurring Revenue

Recurring Revenue refers to the amount of revenue that a SaaS business collects over a stated period of time. In SaaS businesses, recurring revenue refers to the revenue generated in the form of the subscription fee for accessing the software as well as cloud-based services. Such services may include upgrades, maintenance, and support offered by the SaaS provider. Note that recurring revenue can be collected annually, monthly, or quarterly.

Accordingly, Monthly Recurring Revenue (MRR) is a growth metric that enables SaaS or subscription-based companies to forecast their expected revenue for a given month. It is a measure of how much revenue a business generates from the subscription payments that subscribers or customers pay each month.

Likewise, Annual Recurring Revenue (ARR) is a key performance revenue-based metric that measures the amount of recurring revenue to be collected by a SaaS business over a period of one year. In other words, it measures the annual run rate of recurring revenue from the current install base.

Note that recurring revenue is important for a subscription-based business such as SaaS. This is because it showcases the value of contracts and business as a whole. 

Key SaaS Metrics Under SaaS Accounting Basics

Customer Churn

Customer Churn refers to the number of customers that have discontinued their subscription during a given period of time. Churn, or the loss of customers and/or revenue during a set period of time, can significantly impact the growth of a SaaS company. Because of its impact on growth, churn is a must-track metric across the SaaS business lifecycle. 

Customer Lifetime Value (CLTV)

CLTV is a financial metric that determines the projected total gross margin value of a customer over its lifetime. It considers key drivers like Annual Recurring Revenue (ARR), Cost to Serve (CTS), and Churn Rate. A SaaS company in the initial growth phase may only focus on customer acquisition and increasing customer subscriptions. 

However, these drivers do not assess customer growth accurately. Thus, it is equally important for a SaaS business in such a phase of growth to focus on the projected lifetime value of each customer or CLTV. 

Customer Acquisition Cost (CAC)

CAC is the cost incurred to acquire a customer for a SaaS business. CAC is typically compared with CLTV to know the time in which a SaaS company would be able to recover its CAC. 

Key SaaS Financial Reports

GAAP mandates the business entities to prepare the following financial statements: 

1. Profit and Loss or Income Statement

This is one of the key financial statements that record the income and expenses of a business entity. 

2. Balance Sheet

The balance sheet is a financial statement that records the sources of funds of a business entity and the avenues where such funds have been applied or used. 

3. Cash Flow Statement 

The cash flow statement records the cash inflows and outflows of the business entity and determines the net cash earned from business operations by the entity. 

Need Help With Your SAAS Accounting / Tax?

We at freecashflow.io are an agency that focuses on helping online business owners like you. Our partners have worked in multi-billion dollar MNCs such as Warner Brothers, EY, and paramount. If you want a trusted partner to help you with your tax/accounting, Freecashflow.io is here to help.

Alan Chen Freecashflow.io

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