A Guide to SaaS Accounting Software — Everything You Need to Know
Having SaaS accounting software is increasingly becoming a business necessity. There is no let-up in the explosive growth of software-as-a-service (SaaS).
The 2023 State of SaaSOps survey by BetterCloud reveals that organizations use an average of 130 apps.
And the global SaaS market, according to a McKinsey report, could surge to an impressive $10 trillion by 2030.
Yet, besides their revenue potential, SaaS companies are unique and require special accounting solutions.
Unlike most other businesses, SaaS companies operate on a subscription basis. That’s why a guide for SaaS accounting software could be helpful for your new SaaS enterprise.
What Is SaaS Accounting?
SaaS accounting meets the unique operational needs of SaaS companies in the best way possible.
More precisely, the key feature of SaaS accounting is that it considers the subscription billing model of SaaS companies.
The subscription model requires purchasing web-based apps or online software services with periodic payments. As a result, payments to SaaS companies are often made monthly, quarterly, or even annually.
SaaS accounting allows companies to prepare accurate, timely, and relevant financial statements.
Types of SaaS Accounting
A SaaS company can adopt either
- Cash-based accounting
- Accrual-based accounting
Cash method of accounting
Cash accounting happens when financial transactions are only recorded when accompanied by an immediate, simultaneous exchange of cash.
As a result, according to cash-based accounting, you can’t record revenue unless money has hit your bank account or you’ve received the cash in hand.
And on the flip side, in cash-based accounting, you can’t record an expense unless a vendor charged your bank account, you swiped your credit card, or you paid for an item in crisp dollar bills.
While cash-based accounting is fairly straightforward to understand and use, it may only serve small businesses with annual revenue of less than $1-2 million.
Also, cash accounting may only work well when you have only a few non-complex transactions.
|Cash-based Accounting Pros and Cons|
|Simple to use and understand||Not suitable for large or rapidly growing companies|
|Tracks your cash flow in real-time||Not suitable for inventory-based companies|
|Not GAAP compliant|
The accrual method of accounting
Accrual accounting is when financial transactions are recorded after an obligation to pay arises, either by the business or by the client, regardless of the actual exchange of cash.
Accrual accounting is best for big or rapidly growing companies with a high volume of complex transactions.
|Accrual-based Accounting Pros and Cons|
|More accurate reflection of business activity||Complex; requires in-depth accounting knowledge|
|Ensures regulatory compliance||Does not indicate the actual cash position|
Here’s how to visualize the difference between cash-based and accrual-based accounting.
|Cash-based Accounting||Accrual-based Accounting|
|When are transactions recorded?||Records a transaction when cash is exchanged||Records a transaction when an obligation to pay arises regardless of whether cash is exchanged|
|Who uses it?||Suitable for small businesses with annual revenue of less than $2 million.||Ideal for big or rapidly growing companies|
|Why is it used?||Preferred by small business owners because it’s simple||Preferred by investors and regulators|
|Drawbacks?||Does not timely capture the totality of business transactions, like credit sales to customers or debt obligations||Requires expert accounting knowledge to use and understand|
Which Type of Accounting Is Best for SaaS Companies?
TL;DR: Accrual-based accounting is the best choice for SaaS companies.
Take this example.
Most SaaS companies require an upfront payment before providing a service over an extended period.
As a result, should your SaaS business record a $1,200 12-month subscription made in January as the revenue in January?
If so, you would miss that this $1,200 revenue should be equally spread out throughout the year.
Accrual accounting works well with Monthly Recurring Revenue (MRR) and Annual Recurring Revenue (ARR), two of the most critical SaaS metrics.
MRR is appropriately recorded using accrual accounting. In our example above, the MRR would be $100, which is the revenue we will record monthly.
Also, the accrual system is perfect since it complies with Generally Acceptable Accounting Principles (GAAP).
And even if GAAP compliance isn’t an immediate obligation for your SaaS company, the need to comply with GAAP may come along as your SaaS grows and expands.
Business regulators, lenders, and investors will want to see accrual-based financial statements.
How Is SaaS Accounting Different From Traditional Accounting?
The primary difference between SaaS and traditional accounting is how revenue is earned and recorded.
Traditionally, revenue is recognized when you issue an invoice, receive cash, or deliver an item, whichever comes first.
However, in SaaS accounting and following the subscription model, clients often make an upfront payment for a service that will span up to twelve months, sometimes more.
Consequently, you should recognize revenue in steps as the client uses your app.
And a SaaS company may provide an app with a range of features and functionalities that allow clients to upgrade or downgrade — opt in or out.
When utilized by your clients, these options may come with revenue implications you may want to consider.
What Is Revenue Recognition Accounting in SaaS?
According to the accrual method of accounting, revenue is recognized when an obligation to pay arises on the client’s part and not when you’ve received cash.
Accounting standards, particularly ASC 606 and IFRS 15, prescribe the following 5-step process a SaaS business should take when accounting for revenue recognition.
Step 1: Ensure you have a contract with your client: Whether this is a pop-up that requires a client’s agreement to terms and conditions or a more formal document with a hand-drawn signature, a service contract is an essential requirement before a SaaS company can recognize revenue.
Step 2: Identify the consideration: Consideration is the benefit each party receives. This should include your service deliverables along with the client’s payment obligations.
Step 3: Specify the transaction price: Any service contract should spell out the amount the customer will pay, whether for a particular service or range of services, the date the customer should pay it, and any related discounts.
Step 4: Distributing the revenue: Before you recognize revenue in a SaaS contract, you’ll need to figure out how to allocate the transaction price to distinct periods. This is because most SaaS contracts are continuous.
Step 5: Recognizing revenue: Here’s where you finally record revenue. You’ll only recognize revenue when you’ve satisfied your performance obligations in your service contract.
Common SaaS Accounting Challenges
SaaS businesses face three main accounting challenges. These include
- Knowing when to recognize revenue. This is a unique challenge because accounting rules generally require companies to recognize revenue only when a client obtains control of a particular service. In SaaS contracts, however, the client never really receives control of the service.
- Collecting sales tax: While most states don’t require SaaS companies to pay sales tax, states such as Tennessee and South Carolina are not sparing SaaS companies from sales tax. Since the selling territory of SaaS companies often cuts across multiple states, charging and collecting sales tax may present several head-scratching logistical challenges.
- Accounting for expenses: Just like revenues that need to be spread out over time, a SaaS business must identify related expenses used to generate revenue that should also be spread out over time.
How Can SaaS Accounting Software Help With Accounting Problems?
Because of its subscription-based model, SaaS accounting comes with unique timing challenges that may exceed the capabilities of spreadsheets, let alone manual systems, when it comes to financial reporting.
However, modern SaaS accounting software that automates several functionalities, including calculating sales tax, can overcome many of these challenges.
And with the right software, your financials will be crisp, clean, and compliant with state and federal regulations. And easy to understand for managers and owners.