It is no news that the software industry has grown exponentially due to ongoing digital transformation, with $659 bn of revenues forecasted for 2023. A major part of this industry is Software as a Service, with projected revenues of $253.90bn in 2023 and high profitability. Given the size of this sector, it's important to accurately manage the finances by adopting good SaaS accounting practices.
SaaS accounting differs significantly from regular accounting, despite sharing similarities, such as crafting accurate reports, ensuring efficiency, etc. However, SaaS companies' challenges are unique and need a different accounting approach.
This write-up will keep these goals on the forefront and guide businesses about the essential SaaS accounting knowledge, practices, and much more.
What is SaaS Accounting?
SaaS Accounting refers to the specific accounting practices and processes applied to Software as a Service (SaaS) businesses. It focuses on managing and reporting the financial activities and transactions unique to a SaaS business. SaaS accounting encompasses various aspects, including revenue recognition, subscription billing, cost management, and financial reporting.
- One of the primary considerations in SaaS accounting is revenue recognition, which differs from traditional product-based businesses. It requires accurate tracking and revenue allocation based on specific contractual terms and milestones.
- Subscription billing is crucial in SaaS accounting, as it involves managing recurring billing cycles, subscription upgrades/downgrades, and prorated calculations. Proper tracking and recording of these transactions are essential to ensure accurate revenue recognition and customer billing.
- Cost management in SaaS accounting involves monitoring and allocating costs associated with infrastructure, customer acquisition, development, and ongoing operations. It helps SaaS companies understand their cost structure, profitability, and efficiency.
- Financial reporting in SaaS accounting includes generating income statements, balance sheets, and cash flow statements tailored to the unique requirements of SaaS businesses. These reports provide insights into the financial health and critical metrics of the company.
Why is SaaS accounting important?
Accounting for SaaS is important for several reasons:
- It ensures that financial statements and reports accurately reflect the financial performance of the SaaS business, which is crucial for providing stakeholders with reliable information.
- SaaS companies have unique revenue recognition requirements due to the subscription-based business model. Proper SaaS accounting ensures adherence to accounting standards and regulations, such as ASC 606 and IFRS 15, which govern revenue recognition.
- By automating subscription billing, invoicing, and revenue tracking, SaaS businesses can save time and improve operational efficiency.
- Accounting for SaaS provides key financial metrics and indicators that enable in-depth business performance analysis, such as MRR, churn rate, and CLTV.
- SaaS businesses can demonstrate their financial integrity and mitigate risks by reconciling financial data and implementing robust internal controls.
SaaS accounting methods
There are two major accounting methods that SaaS companies deploy, called cash-basis and accrual accounting.
Cash basis accounting records transactions when cash is received or paid out. It focuses on actual cash flow and does not account for revenue or expenses until cash exchange occurs. For SaaS companies, revenue is recognized when the customer pays for the subscription and expenses when payments are made to vendors or service providers.
It provides a clear view of cash flow but may not accurately reflect the financial performance and obligations of the business.
Accrual accounting recognizes revenue and expenses when earned or incurred, regardless of when cash is exchanged. Revenue is recognized when the service is provided to the customer, even if payment is received later. Similarly, hosting costs, development expenses, and salaries are recognized when incurred, even if payment is not made immediately.
It provides a more comprehensive view of financial performance and obligations, allowing businesses to track revenue and expenses in a way that aligns with their business operations. Moreover, you must use accrual accounting if your business has more than $27 million in gross revenues.
SaaS accounting standards
Accounting for SaaS standards encompass principles and guidelines that SaaS companies follow to ensure accurate financial reporting. They typically adhere to established standards such as:
These accounting SaaS standards provide revenue & expense recognition guidelines, financial statement presentation, etc.
Adhering to them ensures consistency, transparency, and comparability of financial information among SaaS companies and facilitates regulatory compliance.
According to GAAP standards, a SaaS business must complete these three financial statements in each financial period:
- An income statement shows your business's revenues and expenditures, telling whether you're making a profit or loss.
- A balance sheet shows the amount of money you owe or are owed by others. It reports the assets, liabilities, and shareholder equity.
- A cash flow statement encompasses the total amount of money going in and out of your company. It merges income statements and balance sheets to show your financial health.
SaaS accounting metrics & KPIs
Following are some important software-as-a-service accounting metrics.
Monthly Recurring Revenue (MRR)
MRR measures the predictable and recurring revenue generated from subscriptions every month. It includes the sum of all active subscription fees for a given month. MRR helps track the growth or decline of subscription revenue over time.
Annual Recurring Revenue (ARR)
ARR represents the recurring revenue generated from subscriptions annually, which is calculated by multiplying the MRR by 12. It provides a broader perspective on the company's revenue trajectory and is often used to assess its overall value.
Customer Acquisition Cost (CAC)
CAC measures the average cost incurred by the company to acquire a new customer, including advertising, salaries, commissions, and overhead costs. It is crucial in determining the efficiency and effectiveness of the company's customer acquisition strategies.
Customer Lifetime Value (CLTV)
CLTV estimates the total revenue a company can expect from a single customer throughout its entire relationship with the business. It considers the average customer lifespan, average revenue per customer, and customer retention rate. CLTV helps in understanding the long-term profitability of the customer base and guides decisions related to pricing, marketing, and customer retention.
The churn rate measures the number of customers who cancel their subscriptions within a specific period. It indicates the customer attrition rate and can be calculated regarding customer count or revenue lost. Monitoring churn rate is essential for SaaS companies as it directly impacts revenue, customer acquisition costs, and CLTV.
Understanding the reasons behind churn and implementing strategies to reduce it is critical for sustainable growth.
Gross margin represents the percentage of revenue left after deducting the direct costs of delivering the SaaS service. Direct costs may include hosting expenses, customer support, and any other costs directly attributed to service delivery. Gross margin is an important indicator of the company's profitability and service delivery efficiency.
Burn rate measures the rate at which a company consumes its cash reserves to cover expenses. It helps determine how long the company can sustain its operations before running out of cash. Burn rate is particularly important for early-stage SaaS companies focused on growth but may not generate positive cash flow yet.
It is crucial to manage the burn rate to ensure the company has sufficient runway to reach profitability or secure additional funding.
Average Revenue per User (ARPU)
ARPU calculates the average revenue generated by each customer on a per-user basis. It is obtained by dividing the total revenue by the number of active customers. ARPU provides insights into the pricing strategy, upselling opportunities, and the overall revenue potential of the customer base.
Cash Conversion Cycle (CCC)
CCC measures the time it takes for a company to convert its investments in inventory, marketing, and other operating expenses into cash inflows from customer payments. It includes the average collection period (time to collect payments), the average payment period (time to pay vendors), and the average inventory holding period. A shorter CCC indicates a more efficient cash flow cycle and better-working capital management.
Return on Investment (ROI)
ROI measures the profitability of an investment by comparing the gain or return from the investment relative to its cost. For SaaS companies, ROI can be applied to various investments, such as marketing campaigns, new feature development, or infrastructure upgrades. Evaluating the ROI helps prioritize investments and assess their impact on the company's financial performance.
Revenue & its recognition
In the context of SaaS accounting software, revenue refers to the income of a SaaS company earned through the provision of its software services.
Revenue recognition is a critical element of accounting for SaaS companies determining when and how revenue should be recognized from software services.
It typically includes recognizing subscription revenue over the subscription term, considering factors like activation criteria and upfront fees. Tied to actual or estimated usage metrics, usage-based revenue is also recognized. The length of contracts and the likelihood of renewals impact recognition, necessitating adjustments for discounts or concessions.
In cases where bundled services are offered, revenue may need to be allocated among the components. Seeking guidance from a qualified financial advisor is recommended to ensure adherence to the appropriate practices in revenue recognition.
Understanding accounting standards, leveraging key metrics, and managing revenue are crucial for SaaS businesses aiming to drive financial success through sound accounting practices.
However, you need to work with a reputable name like Apptension to achieve the desired financial goals. We are one of the leading choices for SaaS businesses that want to see their finances in the right shape. With 10 years in the industry and 94 exceptional experts, you'll be hard-pressed to find a better company with high-quality SaaS accounting solutions like ours.
So, contact us and adopt robust accounting practices to drive growth today!