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How is SaaS Accounting Different from Traditional Accounting?

How is SaaS Accounting Different from Traditional Accounting?

Accounting for SaaS companies can be hard and confusing. Many of the problems are caused by the way SaaS companies deliver their services: Because subscriptions are so complicated, it can be hard to figure out how to apply accounting rules, sales taxes, contract renewals, commissions, and other factors.‍Finance teams need to figure out the details of SaaS accounting to make sure they're reporting and forecasting correctly, as well as staying in line with rules from the Financial Accounting Standards Board (FASB) and the International Financial Reporting Standards (IFRS) and any tax laws that apply.

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How is SaaS Accounting Different from Traditional Accounting?

Accounting for SaaS companies can be hard and confusing. Many of the problems are caused by the way SaaS companies deliver their services: Because subscriptions are so complicated, it can be hard to figure out how to apply accounting rules, sales taxes, contract renewals, commissions, and other factors.

Finance teams need to figure out the details of SaaS accounting to make sure they're reporting and forecasting correctly, as well as staying in line with rules from the Financial Accounting Standards Board (FASB) and the International Financial Reporting Standards (IFRS) and any tax laws that apply.

How is SaaS Accounting Different from Traditional Accounting?

Accounting for the traditional license business model is very different from the subscription business model. In a license-based business, a standard invoice would have the following:

  • First License
  • Setup
  • Customization
  • Support
  • Maintenance

In a SaaS business, however, all of these costs are included in the "subscription fees" or "set-up fees" on top of the subscription fees. How well SaaS works depends on how many customers are willing to keep using the product.

The core of SaaS accounting: Bookings, Billings, and Revenue

Accounting for SaaS companies is comprised of the three core areas below: 

Bookings

Bookings are customer commitments to pay for services. This forward-looking metric represents the value of customer contracts over a given period.

Bookings might be renewed, upgraded, new, or non-recurring (e.g., set up fees or training fees). Bookings with a forward period of at least one year can be examined based on the annual contract value, which only accounts for the current year, or the total contract value, which accounts for the entire contract.

Billings

Billings are the money your customers owe you.

High bookings but low billings can signal future cash flow concerns for your SaaS business. Detailed cash flow statements can be generated regularly to provide this information. Try to convert monthly clients to annual customers by offering discounts or other incentives.

Revenue

In accrual accounting, sales are recognized when services are rendered. Bookings and billings alone can inflate performance metrics. You don't want to assume monthly profit for months just to learn the customer can't pay. Some corporations reduce their accounts receivable by a certain percentage every month they are late, anticipating the longer payment is delayed, the less likely they will receive the money.

Common SaaS Accounting Challenges

Accounting for SaaS businesses brings about a whole host of challenges compared to accounting for other types of businesses. 

Here are some of the common challenges for SaaS accounting:

Revenue recognition

SaaS companies' biggest difficulty is recognizing revenue. Because the client never "takes control" of the software, the general revenue recognition standards don't apply. FASB guidelines mandate SaaS enterprises to record revenue over the contract length. This is referred to as deferred revenue. True whether the SaaS provider receives the full sum upfront or uses a weekly, monthly, quarterly, or annual subscription plan.

Expense management

SaaS providers also have to spread out a lot of their expenses over the length of the contract or the time they expect to work with a customer. It is crucial to take into account which expenses they need to spread out over time and which ones they can pay for right away. The SaaS business has to record expenses at certain times, just like it has to record income at certain times.

Collecting sales tax

Sales tax is another big problem for SaaS providers since they often have remote workers and do business and sales in multiple states. Some states tax software in some or all service categories, even though SaaS companies are not always required to collect sales taxes on their services. When it comes to sales tax, SaaS companies are responsible for the rules in the states where they have nexus.

Deferred revenue

Deferred revenue is the money you've already charged for but can't count as income because the service hasn't been done yet. It is often called "unearned income." On the balance sheet, deferred income is listed as a liability.

When figuring out deferred income, you need to be careful. If you count revenue before it comes in, your growth numbers will be misleading, which will make your growth potential go up. It's also important to know that you shouldn't invest money you haven't earned on projects until you've earned it.

LTV to CAC and other SaaS-specific metrics

SaaS businesses place a big priority on metrics like LTV, CAC, Churn, MRR, ARR and other metrics. That’s because these metrics 

Customer refunds or upsells

Customer refunds can be tricky to handle because the value of the refund can change every month. For pricing models that rely on usage-based pricing, refunding the customer based on the amount of your service they’ve used isn’t easily updated in accounting software.

When updating a customer’s contract with upsells, accounting records have to be updated accordingly. This can cause even more confusion when accounting for deferred revenue and cash burn. 

Revenue Recognition for SaaS Companies

ASC 606 provides a five-step framework for recognizing revenue. These guidelines delineate the appropriate revenue recognition measures and eliminate inconsistencies and ambiguity in SaaS accounting practices.

Identify the contract with a customer: Companies follow this step when they sign new customers up for the service.

Identify the contract's performance obligations: For this step, the provider must make sure the contract explicitly states the services they're providing, how long those services are for (the contract term) and the obligations and rights of the customer and the SaaS provider. This includes listing the service deliverables as well as obligations.

Determine the transaction price: This is the amount the provider expects to receive for providing the contracted services. That figure encompasses the total of all standalone and bundled services as well as any discounts.

Allocate the transaction price: This step requires the allocation calculations from the previous section. Because most SaaS companies work on an ongoing subscription basis, the allocation timeframe for lengthier contracts, say 12 months or more, can be broken down for recognition purposes. That calculation is often 30 days, as it's the smallest billing cycle for most SaaS providers. In a annual agreement that requires payment up front the company must divide that annual amount up by 12 and only recognize 1/12 of the value for each month of the annual agreement. This gets more complicated when Semi-Annual billing or Quarterly billing structures are in place. This is due to each invoice having a different deferred revenue schedule. 

Recognizing revenues upon satisfying the performance obligation: In this final step, SaaS companies recognize revenue as they meet performance obligations and the customer benefits from the service or services provided.

2 Types of SaaS Accounting

There are two ways to handle accounting for SaaS companies, depending on when the sale is put into the books.

Cash Basis Accounting

With cash-basis accounting, income and costs are recorded when cash comes in or goes out. So, when money comes in, it gets added to the ledger, and when money goes out, it gets taken out. This method doesn't take into account who owes money and who owes money. Small businesses and entrepreneurs with little or no inventory often use cash-basis accounting.

Pros

Cons

Simple to maintain

Difficult to forecast

It's easier to figure out how much money a business has at any given time.

Insufficient for large, inventory-heavy businesses

The business only has to pay taxes when money comes in.

It's possible to get a wrong idea of how the business's finances really stand because it doesn't take credit purchases and expenses into account.

Accrual Accounting

In accrual accounting, revenues and expenses are recorded when they are earned, regardless of when the cash actually comes in or when the expenses are paid. Businesses that use accrual accounting have the benefit of not having to report their income on their tax returns right away.

This method is used more often than cash-basis, and even though it is more complicated, it is better for growing businesses with a lot of inventory. The IRS says that a business that makes more than $25 million in gross sales each year must use the accrual method.

Pros

Cons

More accurate representation of actual profit at a given time

Complex and 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

Why SaaS companies need good accounting for fundraising

Incorrect revenue and deferred revenue can be costly. SaaS VCs will request your financial statements during due diligence and expect the figures to match (although providing a bookings ARR number is 100% legitimate and won't be shown in your GAAP financial accounts). If you're going to be acquired, these figures matter.

For SaaS companies that want to raise a round, their financial statements are going to increase or decrease investor confidence. There have been stories of SaaS companies using fake financials to make their company’s performance look better, but this leads to lawsuits and potential issues with the IRS. 

How much revenue does a SaaS company need to raise a Seed round?

Before the second quarter of 2021, the average SaaS startup needed $340k ARR and 600% trailing growth to raise a seed investment. During the hot financing market, commencing in Q2 2021, the average firm needed just under $60k of ARR and was only increasing at roughly 140% year over year. We predict this trend to reverse throughout the rest of 2022 when companies will need stronger metrics to close a deal.

How much revenue does a SaaS company need to raise a Series A round?

Before the second quarter of 2021, the average SaaS firm needed $1.8 million in ARR and 330 percent trailing growth to fund a Series A. When the venture market heated up in Q2 2021, the average business needed $1.2 million in ARR and grew 170 percent annually. Again, size and growth metrics plummeted. We predict this trend to reverse throughout the rest of 2022 when companies will need stronger metrics to close a deal.

How much revenue does a SaaS company need to raise a Series B round?

The average SaaS company needs $11m in ARR and a 12-month trailing growth rate of 180% to raise a Series B. In Q2 2021, the average company needed $3.4 million in ARR and grew by 220 percent. That's a huge decline in ARR, possibly caused by hedge funds bidding aggressively for Series Bs.

On a reduced ARR base, revenue growth makes logical, hence the Series B vs. Series A and Seed numbers make sense. As the capital market cools, we estimate the ARR threshold to rise again in late 2022.

The financial statements needed for fundraising

SaaS companies need three financial statements: Profit and loss, cash flow, and balance sheets. SaaS companies can also use other documents showing bookings, ARR, and more to present to investors. 

  • Increasing Financial Maturity through process & controls
  • Accurate financials drive higher valuations
  • Ability to articulate your financials requires clear detailed numbers and responsive bookkeepers can drive the speed and attention to key questions.

The 3 metrics Saas businesses need for their accounting

As mentioned earlier, SaaS businesses focus on a few specific metrics. Here are the metrics you should be tracking and accounting for:

ARR/MRR

Recurring revenue is made by subscription-based services, and it is usually measured by two SaaS metrics: monthly recurring revenue (MRR) and annual recurring revenue (ARR).

Both are ways to measure how much money you'll make over time. Businesses usually figure out their ARR by first figuring out their MRR and then multiplying that number by 12.

MRR should account for:

  • Recurring revenue from all customers
  • Upgrades and downgrades
  • Discounts
  • Customer churn, or lost revenue

Revenue churn

Revenue churn is the percentage of subscription dollars that a company loses over a certain time period, or the ability to keep the contract value of existing customers.

Burn rate

Burn rate is used to describe how fast a new company spends its capital on overhead costs before it starts making money from operations. It’s a way to measure the cash flow that goes down.

Most of the time, the burn rate is given in terms of how much cash is spent each month. For example, if a company's burn rate is $1 million, it means that the company spends $1 million every month.

How Decimal makes accounting easier for SaaS businesses

Decimal provides accounting operations for small businesses: bookkeeping, technology setup/support, bill pay, payroll, and more. Think of Decimal as your back office on autopilot. 

Here’s why you should work with Decimal:

  • Dedicated accounting team: Led by a cloud accounting specialist, and supported by technology experts, we're designed to support all of your back office needs
  • Automated back office: Decimal leverages technology to simplify your back office and eliminate work for you. It's not just bookkeeping: we'll take care of bill pay, payroll, invoicing, and more.
  • Fixed pricing with no hidden fees: Work with your Decimal team without the worry of extra billable hours. You'll never be charged more than a fixed price, allowing us to work together to best streamline your financial operations.

Contact us to learn how Decimal can help your business.

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