Is Saas accounting different than accounting in any other industry? The answer of course is: absolutely!
Since the end of the last century, the software industry has grown massively. In the last decade especially, many software companies have emerged and made the switch from selling software as a product to software as a service (Saas).
The Saas model offers advantages to both customers and businesses. While it allows for predictable, repeatable revenue streams, it presents a few new challenges when it comes to the financial side of the business.
How is Saas Accounting Different from Other Businesses?
When a typical non-Saas business makes a sale, it’s a single transaction in which a service or goods are exchanged for money.
However with saas companies, instead of an itemized invoice and a one-time exchange, the customer gets access to the service in exchange for a monthly or annual fee. While this consistent influx of money can put the company in a good financial position, it can also make the accounting side of things complicated.
The SaaS model is different from the traditional model because it’s not always easy to know when revenue and costs should be recognized.
Calculating Gross Margin for SaaS
Gross margin is the measure (in %) of what’s left after subtracting the direct cost of goods sold (COGS) from the value of the sale.
Gross Margin % = (Revenue – COGS) / Revenue
For a SaaS business, COGS or cost of revenue can be any cost incurred to support the sale. These can range from the salaries of your customer support staff to the server costs you have for hosting. It can even include the amortization of capitalized development costs.
Cash-basis vs Accrual Accounting
There are two accepted methods of business accounting: Cash-basis accounting and Accrual accounting.
Cash accounting is an accounting method in which expenses and revenues are recognized at the point where the cash is paid or received. When a customer pays an annual subscription in full up front, you recognize that revenue when the cash hits your account.
This method is typically used by smaller businesses with little or no inventory. It can be easier to maintain and it’s easier to keep track of the business’s cash position.
However, it can be more difficult to build a reliable forecast. Further, and especially when credit is involved, it’s possible to misinterpret the financial situation of the business. Lastly, if you’re trying to raise funds from a venture capitalist, they will likely expect your financials to be prepared using the accrual basis.
With accrual accounting, revenue and expenses are recognized during the period in which they are earned, irrespective of whether or not the bank account balances have changed.
Although accrual accounting can be more complicated, it’s much better suited to larger and growing businesses.
Some businesses need to use accrual-based accounting. Those with large amounts of inventory or gross receipts of >$25 Million are required by the IRS to use accrual-based accounting.
Which is Preferable?
For a growing SaaS business, accrual accounting is the better choice. It’s much easier to accurately forecast future expenses and revenues. And it allows for a much more accurate picture of the actual financial situation.
Accrual Accounting for SaaS
In accrual accounting, expenses and revenues are recognized when earned and not necessarily when cash changes hands. Because SaaS businesses normally have a mix of different types of revenue and expenses, this can be helpful for giving a clear financial picture of the business.
For example, a SaaS company generating subscription-based revenue could be billing customers monthly, quarterly or yearly. Additionally, there might also be one-time fees for setup, training or upgrades.
Unlike a physical product business, monthly COGS may not necessarily scale linearly with each incremental sale. Instead, you may see margins increase as you overcome a certain level of recurring costs and only see things like processing fees scale in tandem with revenue.
Accrual accounting allows revenue to be recognized when earned, which is key because it allows the timing of revenue recognition to align with the related expenses incurred to produce that revenue over time. Even though a customer may pay for a year in advance, you would only recognize one month of revenue at a time in your P&L statement.
GAAP Financial Statements and SaaS Metrics
GAAP refers to Generally Accepted Accounting Principles and is the standard for accounting across a wide range of industries in the US. While it’s not required to follow these standards, it is recommended. The further along you get in the fundraising process the more likely it is that you’ll be required to report on a GAAP basis of accounting.
There are benefits as well to following GAAP. Using it to organize all of your financial activity in a consistent manner across your financial reporting, modeling and forecasting helps the management team make better, more informed decisions.
Furthermore, if you’re looking for external investments or bank loans, already using GAAP will speed up the process. Auditors, bankers and investors will use GAAP to evaluate the financial picture of the business.
These days, most businesses are steered by a set of metrics or KPIs. SaaS companies are no exception.
The exact KPIs used depend on the business and specific niche. In addition to standard financial KPIs, there are also KPIs to analyze the sales funnel, KPIs to look at revenue and profitability and KPIs to measure product/market fit.
Bookings, Billings, MRR
Many startups have a strong focus on revenue. Bookings, billings and MRR are commonly used revenue terminology in SaaS.
This metric refers to the value of a signed contract. For example, John’s Lawncare signs a 2-year contract for your appointment-setting software at $50 per month. The total “booking” from that contract would be $1,200.
Bookings are a projection of the sales committed to by your customers. As an indication of future revenue, the finance team can use this information to plan future cash in- and out-flows.
Billings are the invoice amounts actually billed to the customers covering a specific time period.
For cash flow purposes, it’s critical to find ways of encouraging customers to pay upfront and increase billings. This can sometimes be achieved through discounted annual or quarterly payments.
Monthly recurring revenue is the sum of the revenue generated each month on a recurring basis. With subscription-based services and monthly payments, you can count on a certain level of revenue coming in each month.
Get Expert Startup Accounting Help
Often, while focusing on growing the business and building their team, startup founders leave accounting topics until later when the business reaches a certain critical mass. While this is understandable, it’s a dangerous move and there is another way.
Tracking accounting, budgets and key performance indicators all year long are critical components of improving your business’s performance.
If you find accounting topics like this intimidating, get expert help from an accounting service like Founder’s CPA that understands SaaS businesses and the startup industry.