If you’re building a SaaS startup, getting your Software as a Service accounting right should be high on your to-do list.
Growing a successful SaaS business presents some challenges that you’d be hard-pressed to find in any other type of business. Having your financials in order is one of the most valuable ways to ensure your business runs smoothly.
But what is it about Software as a Service accounting that can be so challenging?
Software as a Service Accounting is Unique
SaaS business models are a different breed compared to other types of digital or physical products.
Where many products rely on single-purchase transactions, SaaS products tend to be purchased and used on an ongoing basis. Signing up for a SaaS product generally commits you to pay for the service monthly or annually until you cancel the contract.
Challenges to Software as a Service Accounting
Accounting for SaaS is complex. Even founders experienced with accrual-based accounting might struggle with SaaS because knowing when to recognize revenue and costs isn’t always intuitive.
Typically, you can’t recognize revenue until after providing services. We’ll go into the details later, but ASC 606 is the gold standard for handling SaaS revenue recognition.
Creating a budget and sticking to it is critical for any business, especially with SaaS. Much of the development and customer acquisition efforts occur upfront, while revenue continues as long as the service is operational.
Getting your financial statements to reflect that reality can be tricky.
Further, sales tax can be complicated between having a distributed team and providing services in multiple states (or countries!).
Choosing a Software as a Service Accounting Method
A small business might have a choice between cash and accrual-based accounting. But if you’re planning to scale your business or get outside funding through an IPO or Series A, you’ll need accrual-based financial statements.
The essential tenet of cash accounting is recognizing expenses and revenues when cash changes hands. That means your financial statements reflect income when you’ve received it and costs when they’re paid. This simple method allows for easy tracking of cash accounts.
On the other hand, accrual-based accounting focuses on matching expenses and revenues to the periods in which they’re earned. These adjustments make SaaS accounting more complicated because there’s little to no connection between paying bills and the P&L statement. Cash management requires using a balance sheet and a statement of cash flows.
Accrual accounting is more complex overall but is better because it allows for better forecasting and visibility of future revenue and expenses. Many valuable metrics, like Monthly Recurring Revenue (MRR), are only possible with accrual accounting.
The IASB/FASB (International / Federal Accounting Standards Board) ASC 606 provides a five-step model to standardize revenue recognition. It clearly defines when you should recognize which revenue:
- Identify the contract with a customer
- Identify the performance obligations in the contract
- Determine the transaction price
- Allocate the transaction price
- Recognize revenue when or as the entity satisfies a performance obligation
Essential SaaS Reports
Typically published monthly, financial statements help the company manage performance.
Product and Loss Statement (P&L) – shows how you generate sales, expenses, and profits.
Balance Sheet – outlines how you finance your assets.
Cash Flow Statement – follows money flowing into and out of your business.
Essential SaaS Metrics
Beyond financial statements, there are several metrics and KPIs to help you steer the business. Some are unique to SaaS, while others are more broadly applicable.
Bookings refer to the commitment to pay from your customers and are based on signed contracts and orders in a SaaS company.
Money owed for services your company has provided.
Monthly Recurring Revenue (MRR)
The recurring amount of revenue generated each month. This figure is vital because SaaS is often linked to automatically renewing subscriptions.
Dividing your company’s cash position by your monthly burn rate shows how much time is left before the business runs out of cash. Reducing burn rate through higher net income or lowered expenses can extend your runway.
Return on Ad Spend
Because many of your expenses are upfront, you need to know what’s working and what’s not for product development and marketing. Quickly cutting what’s not working can help you get the most from your advertising budget.
Cost of Goods Sold (COGS)
Calculating COGS is more complicated with SaaS than with physical products. Collect the direct costs necessary for producing and delivering your finished goods:
- Sales commissions
- Development team costs spent on creating, maintaining, and improving your product.
- Expenses for product delivery tools and server space.
- Support staff and the team assisting customers in implementing the tools.
- Customer service staff, if they focus on helping customers get more out of your products.
Any staff costs should include taxes, healthcare, and any other benefits you provide.
Partner with Experts in Software as a Service Accounting
Whether you’re hoping to secure external investment or do a better job of steering your SaaS business, getting your accounting right is essential.
But Software as a Service accounting is difficult to get right on your own. Partnering with an expert can help ensure you’re getting all the information you need and still have time to spend on running your business.
Founder’s CPA specializes in providing full-service accounting to SaaS startups. Contact us today to discuss how you can get started.