This is an accounting guide for new startups and entrepreneurs looking for a well-rounded explanation of SaaS accounting. We go through everything you need to set up subscription billing and accurately recognize recurring revenue.
In this article:
- What is SaaS accounting?
- Cash vs accrual accounting for SaaS companies
- ASC 606 vs IFRS 15
- SaaS accounting challenges with revenue and expenses
- SaaS revenue and expense recognition examples
- SaaS sales tax
What Is SaaS Accounting?
SaaS accounting is the detailed process of reporting income for software companies. Due to the nature of the SaaS subscription model, different from one-time purchases of canned software, customers access cloud software services under term contracts. Companies earning revenue from contracts with customers must follow compliance measures when reporting revenue and filing taxes, to avoid penalties.
SaaS accounting is defined by recurring revenue. A customer will contract with a software business and prepay to use their services for a predetermined time. This is an accounting challenge because SaaS companies are getting paid before a product has been exchanged, therefore, the prepayment cannot instantly be considered income. Instead, the business must wait until deliverables in the contract are fulfilled, then they run through a revenue verification procedure.
Cash vs Accrual Accounting For SaaS Companies
There are two types of accounting methods for use, the cash-basis method and the accrual-basis method. They differ in the timing of when the sale is recorded on accounts. Here is a quick overview of cash vs accrual accounting for SaaS companies:
Cash Accounting Method
Follows the principle of recording revenue and expenses as cash changes hands. It is a simple method to follow: when money is received, it is added to the ledger; when an expense is paid, it is subtracted from the ledger. Due to the time difference, there is no clear financial picture because you can’t see which costs directly affect your profit.
It is atypical for a SaaS company to use the cash method for a couple of reasons:
- The IRS requires businesses holding contracts for longer than a year to record revenue under the accrual method.
- Reporting would be very messy. You would have large variations in revenue throughout the year so your profitability would be difficult to interpret.
- It is a risky business model. Since you record money as it changes hands, and services as they go out, one part of the exchange would be treated as an “I owe you.” Hopefully, it’s you indebted to the customer and not vice versa.
- Investors and lenders appreciate the implementation of verification procedures, that require accrual accounting for recurring revenue. By complying with rules imposed by governing agencies, financial statements are easier to read and analyze.
Accrual Accounting Method
The accrual accounting method is a double-entry method that follows the matching principle. Let’s break that down! A double-entry method is when every business transaction makes an equal and opposite change in at least two different accounts. The matching principle means that revenues and their expenses must be recorded in the same period.
SaaS Revenue And Expense Recognition Example
You sell a subscription and incur revenue, you need to record your commission fees for the sale of that subscription at the same time.
Overall the accrual basis method provides better management of SaaS revenue. Since SaaS companies are dealing with contract-based revenue and future debts of services they work exclusively in accounts that aren’t relevant in cash accounting. A deferred revenue account and accounts receivable are essential to keep SaaS revenue organized and easy to forecast.
Deferred Revenue Account In SaaS Accounting
Accrual accounting offers the ability to defer reporting of customer prepayments. When a customer signs up for a service they agree to a certain payment schedule, usually annually, semi-annually, or monthly. Likewise, the SaaS company agrees to provide a service for a contracted amount of time.
A deferred revenue account will hold customer prepayments until service is rendered. This account helps a SaaS company track its service liabilities and visualize future profit. That way they can take decisive action to reduce taxable business income throughout the year via distributions, dividends payments, making large expense purchases, etc.
Accounts Receivable In SaaS Accounting
Accounts receivable is used for unpaid or outstanding contract charges. When a SaaS company has delivered services, but a client has not paid, the contract will be thrown into accounts receivable. For these types of outstanding payments contracts are lumped into 3 different collection windows 30-days, 60-days, and 90-days. If a SaaS company is unable to work with the client, and the client has failed to pay by 90 days, the contract can be deducted and written off as a bad debt expense.
Why does this matter?
Under the cash method, contractually based businesses cannot write off bad debts. In the eyes of the IRS, the money never existed, because no outstanding payments were recorded on the books as revenue. With accounts receivable in accrual accounting, there is accountability for nonpayments. SaaS companies won’t lose out on money twice—once for the clients’ nonpayment, and twice because they reported a higher income that they owe tax on.
What Is ASC 606 And IFRS 15?
ASC 606, aka Topic 606, is a set of standards for recognizing revenue. These standards were created for organizations that engage in contracts with customers. It brings consistency to reporting sales and revenue from contracts in the business sector. ASC 606 revenue recognition provides an accounting framework that investors, banks, financial professionals, and owners can easily understand.
IFRS 15, revenue recognition is similar to Topic 606 but applies to SaaS businesses outside of the U.S. The United States likes to make its own rules in accounting, to cater to the SEC and the IRS. However overseas the majority of corporations follow the International Financial Reporting Standards (IFRS).
ASC 606 vs IFRS 15
Having two reporting standards can be a hindrance to SaaS accounting. It means that every quarter two sets of financial statements must be procured to comply with national and international standards. Here are some of the major differences between the two that affect revenue reporting for SaaS companies:
- Licensing Right to Use or Right to Access: ASC 606 requires that revenue be recognized over time regardless of whether the license is a standalone functional IP license or a symbolic IP license. In some cases, IFRS 15 requires upfront revenue recognition for symbolic IP licensing.
- License Renewal: ASC 606 does not permit revenue recognition for a license renewal before the renewal period begins. IFRS 15 has no limitations so revenue could potentially be recognized earlier.
- Revaluation of Assets: IFRS states that certain assets can be revalued depending on fair market value, this can apply to intangible assets like software. GAAP only allows a revaluation of marketable securities.
- The Use of Intangible Assets (software patents and copyrights): charged as an expense as they are incurred under GAAP. Under IFRS, they are capitalized and amortized over multiple periods in certain scenarios.
SaaS Accounting Setup
As stated above SaaS accounting is done under the accrual method. In this method, revenue and expenses must be reported in the same period. So having a solid SaaS financial system and accurate procedures is needed. That starts with a SaaS accounting set up to manage these components:
In the following section, we will go through SaaS accounting tools to make your backend stress-free. As well as common revenue, expense, and tax items all SaaS companies should be aware of. As with anything in finance we always advise that a professional perform your accounting.
SaaS Accounting Tools
At the heart of your SaaS business is a good accounting system. We like Xero because it is convenient, user-friendly, and integrates well with other financial platforms. When just starting out you can choose to set up subscription billing in Xero to track all your revenues and expenses, making tax time a breeze.
However, subscription billing automation is limited in Xero. As time goes on, with a higher contract volume, you will want to fortify your accounting to manage the uptick in customer billing minutiae. Making endless journal entries in Xero for each subscription modification is burdensome and prone to errors. We suggest integrating these fintech platforms into Xero:
Xero + Chargebee
Chargebee is a recurring billing service that seamlessly accounts for revenue recognition. You can customize contracts with preset charges that automate accounting for items like add-ons, seats, upgrades, cancellations, tax rates, etc. Chargebee will apply these presets as customers make modifications to contracts and use your service. You then will get a monthly statement showing all revenues to be recognized or deferred to a later period.
Xero + SaaSOptics
SaaSOptics is a subscription management integration targeted at B2B SaaS companies. It is touted for its ability to categorize customer contracts and transfer essential financials to your accounting system. It manages the intricacies of long sales cycles, with many customer touchpoints, and varied pricing models.
SaaS Accounting Challenges With Revenue
SaaS revenue streams can be extremely nuanced depending on what you are offering your customers. As you earn more sales you are bound to discover other profitable opportunities to help your customers, either via new products or enhanced features. Here is a list of different SaaS revenues and how to account for them:
Base Subscription Tiers
Your bread and butter is likely generated by selling services on a recurring schedule. If you are accepting prepayments, you’ll need to spread out revenue for the duration of your contract. Recognize revenue and expenses in installments throughout the year based on customer usage. Reviewing the contracts you hold each month is imperative so that you don’t prematurely recognize revenue.
Contract Modifications: Upgrades, Add-Ons, Bundling, and Discounting
It is difficult to scale a SaaS model without the extra revenue afforded by boosted features and promotions. But they create complex accounting scenarios where you are recognizing pieces of revenue, for the same customer, in different periods. A bonafide SaaS accounting system will take the hassle out of mods to your contracts and normalize them on books. So that you are always recognizing revenue correctly as performance obligations are met.
Custom, Premium, or Enterprise Offers
Like added features, custom packages for your champion customers, add another layer in SaaS accounting. These generate high revenue, so it is your job to cater to this elite clientele and to the unique price points you set. You will experience multiple billing scenarios that will include all of the aforementioned accounting procedures. Note: misstating large revenue items are a red flag to the IRS, and could subject SaaS companies audits and fines.
As a growing company, you will refine your software, adding more capabilities for customers to explore. It is only natural to increase your prices to cover these added costs and to increase profit margins. Generally, SaaS companies will include terms for price changes in their contracts, upping their fees incrementally. To stay compliant, you always should recognize revenue evenly over the life of the contract, even if that means at the beginning of the contract you are recognizing more revenue.
SaaS Expense Categories
One of the reasons why so many entrepreneurs flock to SaaS is the minimal overhead. These are the common expenses you will encounter in the industry that need to be recognized along with revenue:
- General and Administrative: the costs of running the business—day-to-day expenses to run the office.
- Sales and Marketing: promoting your SaaS business is a never-ending expense, there should always be funding allocated to ad campaigns to expand your sales.
- Commission Structures: these expenses are part of payroll, but since commissions, bonuses, and other perks are usually paid monthly or quarterly they accrue on your books.
- Research and Development: the costs associated with the development of new software or beta test models.
- Subscription Fees: these are like your cost of goods sold (ex: any licenses, network fees, or usage fees)
- Depreciation and Amortization of Intangible Assets: each month any software licenses you borrow or sell will have their own set of expenses that need to be recognized for their lifetime.
- Changes in Equity: if you are incorporated, a publicly-traded company, or have silent investors to help with funding your SaaS company, you will need to account for stock expenses and dividends.
SaaS Sales Tax Setup
Many think that because SaaS companies earn revenue they are absolved from paying certain taxes. Not true. Even if you are freewheelin’ your SaaS across crypto markets and pseudo-sheltering yourself, you owe taxes. So it is imperative to have your accounting tech stack infused with tax software to automate collection and payments. Come tax time you won’t be blindsided by any penalties.
Xero + Avalara
Avalara keeps track of sales tax laws so you do have to. They allow you to customize your tax rates for different locations. Plus they tally what you owe to the government, then file and remit state sales tax on your behalf. This weaves right into Xero invoicing so that you can apply proper tax percentages as you recognize revenue.
In many states, SaaS companies are required to collect and pay sales taxes for their products. Rules and regulations vary from state to state and often within the local jurisdiction. Since SaaS is cloud-based, with purchasing and selling of goods happening virtually, it becomes quite complex to stay on top of each state’s sales tax law for all of your customers.
In the map above, the green states charge sales tax on services. Ohio and Connecticut tax SaaS differently depending on whether it is for business or personal use. With ambiguity in tax laws, minor differences can change a company’s tax treatment of customer contracts.
SaaS Accounting Pro
Thriving in the tech industry is no easy feat for budding SaaS companies. To do it you need to stay on course towards independence and profitability. That’s why SaaS accounting should go to the professionals, not consume your evenings. Get help with your books so you can focus on growing your company.