What is SaaS accounting: Standards, metrics & revenue recognition guidelines

What is SaaS accounting?

SaaS accounting refers to recording, analyzing, and interpreting the financial information of your SaaS business. Because of the complexity of accounting in SaaS, most SaaS businesses leverage cloud SaaS accounting software to manage their financial statements and reports.

The most common accounting methods for SaaS companies

SaaS businesses have two options when it comes to accounting methods. There's cash-basis accounting and accrual accounting. The primary difference between the two is when sales revenue is recorded in the income statement. Let's expound on the two.

Cash-basis accounting 

In this accounting method, a business records revenue and expenses only when they receive payment or pay money owed. Cash-basis accounting is mainly used by companies with traditional pricing models or a smaller inventory.

Because revenue and expenses are recorded only when paid, cash-basis accounting does not operate accounts receivable and accounts payable. Cash-basis accounting is favorable when a business wants an easy-to-maintain accounting system. However, it's not a viable accounting system for SaaS businesses, in part due to the subscription pricing model.

Accrual accounting

In an accrual accounting system, a business records revenue when earned and not necessarily when it receives the cash. Like revenue, expenses are recorded when a contract is established and not when incurred. 

This model is advantageous in the sense that your business can better forecast revenue and expenses. Although complicated compared to cash-basis accounting, accrual accounting can better serve quickly growing SaaS businesses.

Keep in mind that the IRS requires all businesses with an average of $25 million in gross revenue to operate on an accrual accounting model.

What are SaaS accounting standards?

Accounting standards are guidelines and principles that enable your business to record and analyze your financial status in transparency. Failure to follow these principles and standards can leave your business open to inaccurate financial health status and forecasts, which for the most part is destructive. 

Who regulates accounting standards?

The Finance Accounting Standards Board (FASB) regulates what is known as Generally Accepted Accounting Principles (GAAP). From GAAP stems all other accounting principles that businesses use. While all companies don't need to follow GAAP, it's important to use them as a foundation for your accounting standards because:

• Most investors use GAAP to analyze the financial position of companies they want to invest in or already invest in.
• These principles are standard across industries, making it easier to do financial reporting and formulate benchmarks. 

Among these standards are three critical financial statements that your business needs in every financial period. These financial statements include: income statements, cash flow statements, and a balance sheet.

An income statement shows your business' revenue and expenditure. It signifies whether your company is making losses or turning a profit. On the other hand, a balance sheet outlines what a business owes and what it's owed. It does so by reporting the assets, liabilities, and shareholders' equity.

To tie them all is the cash flow statement which shows the amount of money coming into and leaving your business. In essence, it reconciles the balance sheet and income statement to determine the financial position of your business.

SaaS metrics to track 

Now that we have that in place, which metrics should you track in SaaS accounting? 

When we talk of SaaS accounting, five key metrics stand out. These metrics are crucial to steering the growth of your SaaS business. In other words, if you need to know whether your business is growing or not, you need to keep an eye on these KPIs. 

Bookings 

Bookings reveal the value and period of a contract. In other words, it shows that a customer has committed to spending a certain amount of money in exchange for your services. They indicate future revenue growth based on cash outflows and in-flows.

Bookings are recorded as deferred revenue since they are committed money and not yet earned revenue.

Billings 

Billings are the payments you invoice customers after successful service and product delivery. Essentially, it's the money that customers owe you. Billing can happen weekly, monthly, quarterly, or annually, depending on the subscription model your business uses. 

For a healthy financial status, billings should be at par with bookings. If billings are lower than bookings, it may imply that you are experiencing a challenge in collecting money owed to you. That said, it's easy to offset this challenge by charging prospective clients before service execution and discounting annual payments to entice more prospects to pay up front.

Revenue 

Revenue is the income your business brings in when you achieve performance obligations (deliver services as stipulated in the contract). This means that you will only recognize revenue once you deliver a service to your clients. 

For instance, if you have a SaaS product priced at $200 a month, and a client signs up for the annual plan at $2400 on May 1, your first actual revenue in May will be $200 even if you billed the client $2400.

MRR and ARR

Monthly recurring revenue (MRR) tracks the total monthly revenue you earn regardless of your client's subscription plan. On the other hand, annual recurring revenue (ARR) is the total revenue you earn from client contracts for 12 months or more.

Tracking ARR and MRR helps you determine your business' revenue growth momentum and when and how to invest based on your revenue. 

Churn rate

Churn rate tracks the percentage of clients who stop using your product in a given time. It's essential to keep tabs on your churn rate as it helps you understand customer retention and satisfaction rate and whether your marketing and customer service efforts are paying off.

Key SaaS revenue recognition guidelines 

Revenue recognition is a big part of the GAAP standards we mentioned above. Simply put, revenue recognition determines when payment is recognized as revenue. In short, it's not revenue until you have fulfilled your performance obligation. 

To understand the revenue recognition guidelines, we first need to put into context two terms: Accrued revenue and deferred revenue.

Accrued revenue

According to the GAAP standards, revenue is recognized when earned, meaning when you fulfill a service. This is known as accrued revenue. It also goes by unbilled revenue since you are yet to bill the customers for what they owe you. 

In cash-basis accounting, you debit accrued revenue as a current asset on the balance sheet. It's an asset as it's money owed to your business by clients. On the income statement, you'll record it as earned revenue.

For SaaS businesses, accrued revenue is typical in situations where:

• The project is long term
• You charge one-time charges to set up, customize, or migrate software
• A product comes with add-on purchase options
  

Deferred revenue

Deferred revenue is also known as unearned revenue. It occurs when clients pay for your product up front and before you deliver services. Since you are yet to fulfill your performance obligations, deferred revenue is treated as a liability.

Recognizing deferred revenue before fulfilling your contractual obligations can lead to inaccurate growth forecasts, which, as we know, is terrible for business.

Revenue recognition guidelines as per ASC 606

As of 2018, both public and private business entities should be ASC 606 compliant. What exactly is ASC 606? 

ASC 606 is the standard accounting guidelines developed jointly by the FASB and International Accounting Standards Board (IASB).

In essence, the ASC 606 guidelines help businesses recognize revenue consistently and ease the preparation of financial statements. Here is the 5-step model for revenue recognition.

1. Identify customer contract 

This step outlines the criteria to be met when establishing a client contract. The criteria include: 

• "Persuasive evidence of an arrangement exists."
• "The seller's price to the buyer is fixed or determinable."
• "Collectibility is reasonably assured."
• "Delivery has occurred or services have been rendered."
  

2. Determine performance obligations 

This step determines how the performance obligations of a contract should be handled. The contract should explicitly define what services are offered, the period of providing these services, and the rights and obligations of each party.

3. Define the transaction price 

This guideline determines what is to be considered when setting a transaction price. The price will need to factor in standalone fees, subscription services, and discounts. 

4. Allocate the transaction price  

This step outlines the allocation of transaction price across multiple performance obligations of the seller. You'll need to figure out step three first before allocating the transaction price. Depending on your subscription model, the transaction price can be broken down into smaller chunks. For most SaaS companies, that's 30 days. 

5. Recognize revenue 

This step specifies when and how revenue should be recognized. In our case, revenue is only recognized once the SaaS provider delivers as per the contract agreement.

SaaS accounting FAQs 

How is SaaS accounting different? 

One aspect that makes SaaS accounting different is the dynamics of cash flows in SaaS businesses. For instance, recurring payments and the ability to downgrade, upgrade or purchase add-ons make SaaS accounting different from traditional models. Furthermore, the success of the SaaS business is dependent on whether customers are willing to make recurring payments to access a product. 

What is SaaS revenue recognition? 

SaaS revenue recognition is a principle that determines the period when payment (cash) by clients is recognized as revenue in financial statements. The pre-payments made by clients before service delivery are treated as deferred revenue, and hence, a liability.

When can you recognize SaaS revenue? 

For SaaS businesses, revenue is recognized once a client receives and starts to relish the benefits of a service. Or in other words, when a SaaS provider fulfills their contractual performance obligation.

What are the criteria for revenue recognition?

As per the Security Exchange Commission, SAB 101, contracts must meet these criteria before revenue is recognized.

• The price can be determined. SaaS businesses already fulfill this criterion as subscription price is predetermined. 
• The collection is probable. This states that the provider should have a reasonable estimate of cash owed, and if not, defer sale recognition until payments are cleared.
• There is persuasive evidence of an arrangement. In a SaaS model, evidence of contract happens when a client signs up for your product or service. 
• Delivery has occurred. For SaaS businesses, this means recognizing revenue once you have delivered services as per expectation.