Overview
It turns out the rules around systems that are currently labeled as SaaS business are much more different from the rules that will be more familiar to traditional software license business.
Moreover, the rules of cost accounting of revenues have recently been amended for SaaS companies.
Since the revenue and gross margin performance indicators are common among investors and other stakeholders when analyzing SaaS companies, accounting rules are critical to the perceived value of the relevant company.
Companies will be able to gain new insight into the critical difference of accounting for SaaS as opposed to traditional software license; how the recent rules changes will impact their company from this article.
SaaS business model is quickly become widely adopted rapidly being embraced by the market.
Businesses that sold software in the past and wanted to explain their offering typically fall into the product software category are now offering SaaS and many new SaaS businesses are being launched.
The software‐as‐a‐service model can be described as an old model but which has been previously called authorized service provider (“ASP”) or hosted service model.
However, there are number of recent trends that are converging to make this a much more common and frequently preferred software delivery model including:
Access to global, high-quality PaaS or other cloud computing infrastructure services.
Google, amazon, Microsoft and other giants these giants provide the start‐up SaaS companies the opportunity to place a service offering in the market rapidly with less investment on physical infrastructure and less capital.
A change of mindset concerning the issue of supply chain security.
Traditionally, SaaS was considered as a relatively insecure model because company data and systems are not directly controlled; however, more recently, the SaaS model is being increasingly described as capable of being more secure, taking advantage of accessing state of the art hardware and software security.
User’s request for a solution that grows with the user’s needs. Companies are now seeking for systems which can be deployed easily along with low initial investment and have an added advantage of having lower TCO since there are recurrent costs associated with system maintenance required over its lifespan.
However, with the increase of the Software as a Service economy in recent years, accounting practices have also changed.
But it begs the question – when does a SaaS business need to start getting serious about its accounting? Is it during the startup phase, during their mid-transition to SMB or when they have fully transitioned to an enterprise level business?
The answer is No, from the absolute beginning. Urgently, the company has to keep track of its cash flows irrespective of its stage of the development.
For that reason, accounting becomes important. That is why this guide contains the fundamentals of SaaS accounting, and a few more things that might be above the basic level but will help the finance executive, as well as the founder, who sometimes also becomes an accidental finance executive.
Posing as we discuss exploring the fundamentals and moving deeper, here is a rich list of essentials for the SaaS Finance teams.
How is SaaS Accounting Different
The subscription business model is fundamentally different from the traditional license model.
In a business with a license model, a standard invoice would contain:
- Initial License
- Implementation
- Customization
- Support and Maintenance
However, in a SaaS business, all these charges are bundled into the ‘subscription fees’ or ‘set-up fees’ over the subscription fees. The success of SaaS depends on how many customers are willing to use the product on a recurring basis.
Other key differences in SaaS accounting are:
- Cash flow dynamics are more complex thanks to recurring payments
- Lower Cost of Goods Sold (COGS), primarily consisting of sales and marketing, hosting the product and support.
- Higher gross margins, ranging from 60%- 80%.
Calculating Gross Margin for SaaS
Gross margin shows an extent to which the company earns its revenue from the cost attributable to manufacturing the product or delivering the services, i.e., total revenues less cost of sales. Let’s start with a few definitions:
Revenues: Revenue refers to the amount of money you make after rendering your service to the customers.
Cost of goods sold (COGS): This includes cost incurred in the production of goods. With that in mind, here is how to calculate the gross profit margin:
In other words, the gross margin of a SaaS company is gross profit divided by sales, invariably expressed in percent.
Because it is the cash profit of the business which is used to pay for operating expenses incurred during the period.
The higher the gross margin the more dollars a business can have to invest for growth.
Types of SaaS Accounting
Accounting methods are classified extremely into two approaches depending on the time period when the sale was put in the account.
Cash-basis accounting:
On the other hand; the cash-flow measurement of accounting, also known as the cash-basis accounting measures income when cash is received and expenses when cash is spent.
When a payment is received, each addition is made to the total amount on ledger and when a payment is made, each subtraction is made from the total amount on ledger.
Analysing it does not incorporate accounts receivable and payable into consideration.
Cash-basis accounting is actually preferred by small businesses and young entrepreneurs who have little or no stocks at their disposal.
| Pros | Cons |
|---|---|
| Simple to maintain | Difficult to forecast |
| Easier to track how much cash a business has at a given point of time | Insufficient for large, inventory-heavy businesses |
| The business is taxed only when the cash hits the bank account | Possibility of misinterpreting the true financial situation of the business as it doesn’t take credit purchases/expenses into account |
Accrual Accounting
Contrary to the cash-based accounting in Accrual accounting, revenues and expenses are accounted for immediately they are earned or received and when expenses are incurred respectively. With the help of accrual accounting, businesses have a possibility to defer the revenue reporting at the tax returns.
It is used more frequently than the cash-basis and while it may sound complex, it is preferred by growing businesses with many inventories. According to the IRS, a business is expected to use the accrual method if their gross receipts per year exceed $25 million on average.
| Pros | Cons |
|---|---|
| More accurate representation of actual profit at a given time | Complex, requires intense bookkeeping |
| Easier forecasting of future expenses and revenues | Income can be reported when the sale is incurred. So, the business pays taxes on money it hasn’t received |
What is Meant by ‘Recording Transactions’?
Recording of Transactions: A word-by-word explanation of what is meant by the term ‘recording of transactions.
In the existing section, we have realized what cash and accrual accounting specify about ‘when’ to do the transaction.
But what is meant by ‘recording a transaction’ in particular?
Every business must make an account of all the transactions it has made in a journal. This is called bookkeeping.
Accounting helps business organizations make fundamental decisions concerning operations, capital expenditures and financing.
It provides the details of the transactions and prepares the statement of the position of the company.
Proper records also have an effect to users that are outside the business and they include investors, financial institutions and even the government.
Accounting helps firms to present the required information to such parties to help in evaluating the current operations.
For instance, failure to surrender certain records to the IRS attracts some form of punishment. Record also plays a fundamental role when investors and lenders want to check the health of the investment.
Accrual Accounting for SaaS
With the subscription business model, SaaS accounting is a little more complex than what has been described.
Perfect example: The revenue is regularly adjusted (for instance, through plan changes: up or down), and it blurs with one-time charges and initial payments.
Monthly Recurring Revenue (MRR) is a measure used in SaaS companies and Accrual accounting benefits subscription companies because if revenue is accrued properly it reflects the MRR.
It provides equivalent trends for SaaS businesses since it indicates that it’s possible to track revenues and the expenses concurrently in the corresponding period.
Accumulation policies vary depending on the time when the income is identified. Below is a comprehensive guide on the Revenue recognition in SaaS businesses.
GAAP Financial Statements & SaaS Metrics
The procedures for preparing and presenting the financial statements that implement the rules and guidelines are included by accounting standards.
GAAP (US) is an accounting standard by the Financial Accounting and Reporting standards since it is governed by the FASB.
The other option available for most other countries is the IFRS read more: International Financial Reporting Standards which is overseen by the International Accounting Standards Board IASB.
The purpose of accounting standards is to:
Reduce differences between how companies in different industries manage accounting of similar transactions by enhance comparability and reliability in financial reporting across businesses and industries.
The narratives must enable investors and stakeholders understand as well as analyze the differences in the financial statements of different companies and different industries easily.
As per GAAP, three financial statements are required:
- The income statement: There are only two parts – namely income and expenditure. It is also referred to as the Statement of Earnings or just Profit and Loss (P&L) statement.
- The balance sheet: It equates fixed assets to liabilities; it equates shareholders’ fund.
- The cash flow statement: It reports on cash receipts and payments, which is totally missing in the other two statements of financial activity.
FAQ’s
What are the types of SaaS accounting?
Cash-Basis Accounting: Revenue and expenses are recorded when cash is received or paid.
Accrual Accounting: Revenue and expenses are recorded when they are earned or incurred, regardless of when cash is exchanged.
How are transactions recorded in SaaS accounting?
Transactions in SaaS accounting are captured through recurring payment tracking, subscription fee collection, and related expenses which would allow revenue to be tracked at the right times while meeting some accounting standards. The standard it aims to observe is ASC 606.
What is Monthly Recurring Revenue or MRR?
MRR can be described as predictable monthly income generated from currently active subscriptions.
What is Customer Acquisition Cost (CAC)?
CAC is the cost of acquiring a new customer, including marketing and sales expenses.
What is Customer Lifetime Value (CLTV)?
CLTV is the total revenue expected from a customer over their entire relationship with the company.
What is Churn Rate?
Churn rate is the percentage of customers who cancel their subscriptions within a given period.
How do SaaS companies recognize revenue?
Revenue recognition for SaaS is based on the ASC 606 standard, which requires that revenue be recognized at the point when control of the promised goods or services is transferred to the customer, based on performance obligations.
Can you provide an example of revenue recognition for SaaS?
Provide an example of revenue recognition for SaaS. Suppose a company offers a monthly subscription service for $100 and a customer sign up for 12 months.
The company would recognize $1,200 in revenue over those 12 months although the customer paid the money upfront.