Senior Writer: Priya Naha
Summary: SaaS accounting is the process of analyzing, interpreting, and recording your SaaS businesses’ financial statements and information. The blog will take you through some of the most important concepts relevant to SaaS accountants.
Software and SaaS is one of the fastest-growing IT business models in the present decade. It is expected to grow by 11.8% in 2023. And with the upsurge in the SaaS economy, accounting practices have also evolved
SaaS businesses must start with SaaS accounting software from the early stage itself. Any SaaS business, be it a startup or multinational company, must keep track of the cash flow statement.
If you have no idea about accounting SaaS, you’ve come to the right place! We’ll help you with the basic and not-so-basic concepts of SaaS accounts, SaaS accountants and accounting for SaaS companies .
What is SaaS Accounting?
SaaS accounting is the process of analyzing, interpreting, and recording your SaaS businesses‘ financial statements and it is a model for accounting software where the service provider hosts the application.
As accounting for SaaS software is complex, numerous SaaS startups use cloud SaaS accounts software to manage financial statements and reports.
How is SaaS Accounting Different?
The SaaS accounts subscription business model is primarily different from the traditional license model. In a business with a license model, a standard invoice contains:
- Support and Maintenance
- Initial License
But, SaaS accounting software is different in the following ways:
- Lower Costs of Goods Sold (COGS) consist of marketing, sales, hosting support, and the product.
- Higher gross margins, ranging from 60-80%
- Cash flow dynamics are more intricate thanks to recurring payments.
Calculating Gross Margin for SaaS
Gross margin states how a company generates revenue from the cost involved in producing the service or product, i.e., revenue less than the cost of sold goods.
Let’s begin with a few simple definitions:
It is the income earned when you provide service to the customers.
Cost of Goods Sold (COGS)
It includes the cost involved in manufacturing and producing goods.
This is how you can calculate the gross profit margin:
A SaaS company’s gross margin is the gross profit as a percentage of sales. It is crucial because it represents the cash amount a business generates to cover the operating expenses. For example, if the gross margin is higher, the business can reinvest more money to grow better.
Types of SaaS Accounting
Cash Basis Accounting
Cash basis accounting is the process which deals with revenue and expenses when the cash is received or paid. So, when you receive a payment, it is added to the ledger and subtracted when a cost is incurred.
Cash basis accounting does not take accounts payable and receivable into account. Such a type of accounting is used by entrepreneurs and small businesses with less or no inventory.
Pros of Cash Basis Accounting
- It is simple to maintain.
- You can tax the business only when the cash is in the bank account.
- It is easy to track the amount of money a company has at a given time.
Cons of Cash Basis Accounting
- It isn’t easy to forecast.
- It does not take credit purchases and expenses into account. So, there is a possibility of misinterpreting the actual financial business situation.
- It is insufficient for large and heavy inventory businesses.
Accrual accounting is the process which deals with the recorded expenses and revenues when they are earned regardless of when costs are incurred or the cash comes into the account. Businesses that use this accounting type benefit from deferred revenue reporting on tax returns.
Accrual accounting is complicated, but it is a more commonly used method than cash basis accounting. It is more suited for inventory-heavy and growing businesses.
Pros of Accrual Accounting
- It is easier to forecast future expenses and revenues.
- It has a more accurate representation of actual profit at a given time.
Cons of Accrual Accounting
- You can report the income statement when the sale is incurred. So, businesses have to pay tax on money it hasn’t received.
- It is complex and requires intense bookkeeping services.
What is Recording Transaction?
Recording a transaction is the process of accounting transactions for a business in numerous accounts like journal books, cash books, ledger accounts, profit & loss accounts, and others. These entries serve as a shred of evidence for the transactions taking place in the company.
Every accounting for SaaS management software companies has to record financial transaction prices in a ledger. And the process is known as bookkeeping. With bookkeeping, companies can make essential investments, operations, and financing decisions. In addition, bookkeeping helps to give the current financial position of the company and a clear record of the transactions.
Accurate bookkeeping also suggests external users like financial institutions, investors, and the government. With bookkeeping, businesses can get the necessary information that these parties request, which is essential to assess their ongoing operations. For example, if you do not provide a record to the Internal Revenue Service (IRS), it can lead to penalties.
Bookkeeping also serves as an essential record for lenders and investors to check their investment’s health.
Accrual Accounting for SaaS
Accrual accounting for SaaS is necessary because of subscription business and software as a service models comprising mostly routine charges, mixed with one-off fees and upfront payments.
SaaS and subscription business models obsess over Monthly Recurring Revenue (MRR) for their business growth. Accrual accounting, along with revenue recognition, lays the groundwork for this mighty SaaS metric.
Accrual accounting for SaaS is crucial for several reasons:
- Better decisions and clearer cash flow.
- Track MRR with accuracy.
- Identify business trends and bank transfers.
- Comply with international accounting standards.
GAAP Financial Statements and SaaS Metrics
Accounting standards enlist the rules and guidelines for financial accounting and reporting. Financial Accounting Standards Board (FASB) regulates the Generally Accepted Accounting Principles(GAAP) accounting standard.
International Financial Reporting Standards (IFRS) is the alternative for most other countries, and it is regulated by the International Accounting Standards Board(IASB).
Accounting standards have two purposes:
- Make it easy for stakeholders and investors to compare and comprehend the financial statements across industries and companies.
- Bring standardization and transparency in financial reporting across companies and industries by eliminating variations in how businesses across various sectors handle accounting for similar transactions.
According to GAAP, three financial statements are necessary:
The Balance Sheet
It sets assets equal to shareholders’ equity and liabilities.
The Income Statement
It consists of expenses and revenues. Its other name is Profit & Loss (P&L) statements.
The Cash Flow Statement
It records cash outflows and cash inflows that are primarily ignored in the other two statements.
Bookings, Billings, MRR
There are a few top-notch SaaS metrics that every software as a service accounting company must track. To comply with GAAP principles, understanding these key metrics is essential. From the accounting SaaS perspective, we need to understand bookings, billings, and revenue.
Booking is a forward-looking metric indicating the value of a contract signed with a prospective customer for a specific period. In short, bookings signify commitment from your customers to pay the money for the service you offer.
There are various types of bookings, including new bookings, upgraded bookings, and renewal bookings. For multi-year contracts, bookings with at least one year’s committed revenue are known as Annual Contract Value (ACV) Bookings.
ACV comprises annual amounts, but Total Contract Value (TCV) Bookings are calculated by considering the complete duration of the contract. In addition, there are non-recurring bookings consisting of one-time fees like training fees, set-up fees, and discounts.
Bookings are an essential indicator of future revenue growth. It helps measure the development of sales over time. Bookings also help finance teams and CFOs in planning cash outflows and inflows. Moreover, it helps the finance teams to report bookings as committed money without recording them as revenue and avoiding inaccurate calculation of MRR and ARR (Annual Recurring Revenue).
Billing is the invoice amount billed to customers. It can be over a certain period, for example, over a month or the whole year. In short, billings include the money owed to your customer.
Therefore, you need to remember that if software as a service accounting has high bookings but lower billings, it indicates future cash flow problems. To maintain healthy cash flows, SaaS businesses need to think of ways to get customers to pay upfront and increase billings. You can do it by offering discounts on annual payments.
Revenue is the income you earn when you provide service to your customers. For successful service delivery every month, you can recognize revenue for that month.
According to the GAAP rules, revenue recognition is possible once you earn it.
Therefore, if you rely only on billings and bookings to assess performance, you are looking at inflated numbers. A better and more accurate way is to keep tabs on recognized revenue. It is the amount the business earns in exchange for the service or product.
Revenue Recognition Accounting for SaaS Companies
Revenue recognition is one of the standard principles of Generally Accepted Accounting Principles (GAAP). It offers the condition through which you can recognize revenue and a way to account for it in the financial statements.
Before we delve deeper into revenue recognition for SaaS accounts, we need to understand a few key concepts.
Accrued revenue is the revenue that is not realized but recognized. It is the revenue recognized/earned by a business for which the invoice is yet to be billed by the customers. It is also known as unbilled revenue.
Accrued revenue is managed as accounts receivable until the customer pays the bill. So, it is a current asset on the balance sheet. But, a high accrued revenue signifies that the business isn’t getting payments for the services, which can be alarming from the cash flow perspective.
In SaaS accounts, revenue is accrued in cases like:
- Add on purchases in the subscription period
- Plan-based and quantity-based upgrades
- One-time charges like set up/migration fees
Deferred revenue is the money already billed, but it can’t be recognized as revenue because the service is yet to be provided. It is most preferably known as unearned revenue. Deferred revenue is listed on the balance sheet as liabilities.
Ensure that you are careful while calculating deferred revenue. If you recognize revenue before it is earned, you will misinterpret your growth numbers, which spikes your growth potential. It is crucial to know that this un-earned cash must not be interested in your future projects until it is earned.
ASC 606 and SaaS Revenue Recognition
IFRS and FASB joined hands to set up a new revenue recognition standard called the ASC 606. ASC 606 revenue defines a robust five-step framework that is flexible and encompasses the revenue recognition principles across industries. It has cleared up the confusion looming over SaaS accounts due to unclear and inconsistent practices.
The five-step framework includes:
Contract Identification with the Customer
When establishing a contract term with SaaS customers, you must meet the criteria to provide services and products. In addition, the contract must be mutually agreed upon and define the obligations and rights of each party.
Identification of Performance Obligations in the Contract
It describes the deliverables or the performance obligation when the contract is drawn
- The products and services need to be accounted for separately if they are distinct.
Determination of the Transaction Price
It enlists all the considerations that must be taken care of while establishing the transaction price.
Allocation of the Transaction Price
It explains how transaction price is allocated across all the performance obligations mentioned in the contract. It also includes the variable amounts.
Recognized Revenue When (or as) the Performance Obligation is Satisfied
Revenue can be recognized over time as or when the customer benefits from your service or product and is driven by the transfer of control to the customer.
However, this is just a one-dimensional perspective. Revenue recognition in accounting SaaS has multiple complex scenarios caused by subscription downgrades,
upgrades, refunds, cancellations, and others.
Making SaaS Accounting Software Easy
As a growing SaaS business, using spreadsheets is cumbersome as it is prone to errors and time-consuming at the same time. Moreover, with scale, the revenue workflows may develop leaks and cracks. And the key to fixing these leaks is automated repetitive tasks.
All scaling SaaS companies need a specific tool that can manage subscription and recurring billing on the one hand and streamline financial reporting operations on the other.
So, ensure a SaaS provider that makes reporting, recognizing, and staying compliant easy, while managing seamless integration of recurring billing.
Frequently Asked Questions
Accounting SaaS is different as it has revenue tracking owing to the subscription model used by SaaS businesses.
SaaS revenue recognition is the process of converting money from bookings into revenue.
You can recognize SaaS revenue when the services are rendered.
A SaaS startup needs an accounting system from the time of its inception.
Yes, SaaS companies have accounts receivable. It comes from failed credit card payments.
Many SaaS providers use the accrual accounting method, which means that they record revenue when the sale is made and not on a cash basis that records revenue when you receive the money.