The service as a software (SaaS) industry is expected to see a 15% increase from 2020, with an estimated growth of $121 billion in 2021.
However, with this explosion of subscription-based software tools and programs comes the daunting challenges of accurately evaluating and managing the finances of such an endeavor to keep a SaaS company viable and competitive.
Understanding the financial operations of a SaaS business is imperative to its success. Having a clear picture of the money flow is crucial so performance can be explained efficiently to forecast revenue effectively.
In addition, accurate reports and bookkeeping lead to financial transparency and provide relevant feedback so that businesses can make proactive decisions based on precise information.
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Why SaaS Accounting is Different
Old fashioned spreadsheets, systems, and manual processes might still work for traditional software companies, even though they are time-consuming and prone to human error and costly mistakes.
But for a SaaS business, more complicated financial considerations must be measured and managed consistently to understand and adequately calculate growth and revenue.
Accounting for SaaS companies is more complicated than a traditional software company because of the subscription-based model employed in most software as a service business. Customers pay for a product that provides a service over an extended amount of time and can potentially have additional costs and fluctuations throughout the service’s lifetime.
Additionally, these software services require maintenance, especially when a consumer changes their plan: upgrades, opt-in and out of services, or even downgrades.
An accounting plan must be equipped to gauge this type of software service that involves recurring billing and software management that is the heartbeat of a SaaS company.
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Key Elements of SaaS Accounting
Reliable SaaS accounting provides accurate insight into the business’s operations and revenue. Having a clear picture of money in and money out and knowing when and how to account for revenue is critical to any business; however, it is even more crucial for service as software companies who rely on a business model that renders their service over an extended period.
In addition to understanding the current state of finances within the company, having the financial records and financial forecast up to date makes raising venture capital more streamlined. Clear, reliable financial records, including profit and loss, income statement, cash flow, and balance sheets, will give investors or buyers and board members and government compliance agents clear insight into the company’s proper financial health.
System Infrastructure
Cash vs. accrual
In a traditional software business, a purchase is made, software exchanges hands, and the money is recognized immediately, known as a cash accounting method. Money and services are exchanged at the time of purchase. Costs and expenses are subtracted from the revenue earned, and a clear picture of finances is established.
This is common and acceptable accounting practice for small businesses with physical products or little to no inventory.
But for a SaaS subscription model, money exchanges must be recognized over the entirety of the subscription’s contract. Due to performance obligations, the money is not fully earned until the service has been rendered to the client in full.
For instance, a customer may pay for an annual cost upfront but that revenue is earned throughout the year as the service is delivered continuously. Accrual accounting tracks money as it is earned or due, not when the money changes hands (Zeni).
Investors, financial institutions, and government regulators most commonly require accrual accounting. Therefore, it is wise to begin accrual accounting practices as soon as possible in a SaaS business, from the very start if possible.
It will save time-consuming and potentially costly adjustments should the company grow large enough to be required to follow GAAP standards or should the company seek investors or even pursue an acquisition. Getting ahead of the requirements for SaaS accounting best practices in advance of a pinch point is always ideal.
GAAP-Complaint Financial Management
General Accepted Accounting Principles (GAAP) are standardized accounting methods used across all industries and recognized by financial institutions and government regulators alike. It is a set of accounting rules, guidelines, and regulations that create consistency and transparency regardless of the organization and industry generally accepted internationally.
Getting on board with GAAP compliance, in addition to accrual accounting, is beneficial from the start of a company. Establishing preferred accounting practices will make it easier to approach investors or banks for loans because financial projections, which are the lifeblood of a SaaS company, will be accurate and up-to-date.
Should the business be audited, accounting practices consistent with GAAP standards will make that process less complicated. Should the company seek to grow past a start-up, investors and financial institutions will require GAAP compliant financial reports.
Though some companies may choose not to start GAAP from the start due to the expense of hiring the expertise of an accountant, finding an affordable solution should be a primary concern to becoming GAAP compliant to maintain SaaS best accounting practices.
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SaaS Financial Reporting and Metrics
Investors, financial institutions, and the IRS want to the accurate financial records of a company and have a clear understanding and scope of a company’s financial numbers.
These reports and metrics are standard across industries, SaaS companies not being an exception. These reports and metrics give a detailed and specific itemization and accounting for all financial aspects of the business.
SaaS Reports
- Profit and loss is the income statement that gives a summary of revenue and expenses. Over time, a Profit and Loss (P&L) statement showcases how a company generates sales, manages expenses, and creates profit.
- A balance sheet shows a company’s assets and how they are financed. It is also referred to as a statement of financial position or statement of net worth. In essence: Assets = Liabilities + Equity (Financial Institute).
- Cash flow shows the money that is consumed and generated over a specific time frame. It is different from income in that income is based on accrual accounting, while cash flow is the cash on hand that the company is working with.
SaaS Metrics
- Bookings: are the commitment that a consumer makes to the SaaS company through subscription services and recurring costs for the service provided. Bookings help finance teams measure future revenue growth and help SaaS businesses understand sales efforts.
- Billings: is the money owed to the company that provides the services. It is the invoice that is billed to the customer. Bookings and billings must be monitored because they indicate potential cash flow problems down the road if they do not line up.By having customers pay upfront, billings and cash flow are increased and match bookings more closely. Sales and discounts for upfront or bundled services can help increase billings and decrease potential cash flow down the line.
- Revenue: It is crucial to know when and how to account for money earned. A company must learn when to recognize revenue properly and to understand when revenue recognition is deferred revenue.
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Revenue Recognition
When service is remitted successfully to the customer, and the billing is paid for the booking, income is earned, which is revenue. This exchange is recognized as income for that month of accounting. The money is considered earned as the customer’s contract is realized month by month, especially in the case of those who sign up for annual installments. haTt annual fee is spread throughout the year, as goods and services are provided to the customer.
Deferred Revenue
If revenue is calculated before it is appropriately earned, misinterpretations of financial numbers can lead to miscalculation of growth numbers. This money is considered unearned until the service matches the money spent, which is especially important should a customer cancel a contract. This money should never be considered usable until the contract has been fulfilled.
For example, consider a customer who pays for an annual subscription upfront. Though the money has changed hands, the payment is not counted as revenue or income yet. Accurate accrual accounting would portion the payment into monthly installments that reflect service earned. As the money is earned, that portion of cash moves from deferred revenue to revenue, thus avoiding any miscalculations or potentially spending the money before it is earned. In this way, SaaS businesses can account for money flow and accurately account for what is recognized revenue (ChargeBee).
- MRR and ARR: Monthly recurring revenue (MRR) and annual recurring revenue (ARR) are two measurements used to calculate a predictable revenue stream. Accrual revenue is a valuable metric to have a clear picture of MRR. Accurately tracking accrual revenue gives a good forecast and will track MRR and ARR.
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Automation is Key
Growing a SaaS business can be rewarding and exciting, but without good SaaS accounting practices and management, the company’s financial side may become a complicated web of confusion.
The key to quality SaaS accounting is automated systems that manage customer subscriptions, handles recurring billing, and streamline the bookkeeping, accounting, and tax services. Best accounting practices for SaaS companies most likely will require an experienced accountant to handle the accounts, but in the long run, the cost is worth the potential fallout accounts, and finances are not managed correctly.
Keeping the books accurate and organized adequately from the start can give a SaaS business a leading edge so they can focus on growth through accurate and precise financial metrics rather than leaving it to chance later down the road.
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References:
- thesaascfo.com/role-of-finance-accounting-in-saas/
- chargebee.com/blog/best-practices-in-revenue-recognition/
- saasoptics.com/blog/get-saas-accounting-and-financial-operations-right-from-the-start/
- zeni.ai/blog/gaap-accounting-for-startups
- corporatefinanceinstitute.com/resources/knowledge/accounting/balance-sheet/