Note: This article is part of my deep dive series on SaaS metrics
On the surface, accounting at a SaaS company may look like accounting at any other business.
Every company has some way to track income, expenses, assets, and liabilities. Due to their unique business model, SaaS companies will have some industry-specific variations in their accounting practices. Their financial statements will also have very different metrics and ratios than other online business types.
At its simplest, accounting is the recording, reporting, and analysis of the financial data for a business.
How does this apply specifically to SaaS companies and other subscription-based business models? You’ll find out in this article.
What Is SaaS Accounting?
Accounting in SaaS companies is the documentation and interpretation of the financial data for the business over its entire life.
And yes, this starts at the very birth of the company.
Accounting for the business starts from the moment money first changes hands. This might be a loan or investment you receive to fund your idea. It might be the first dollar you spend from your own money to launch the company. Or, if you’re lucky, it might be the first dollar you make from an early adopter on your minimum viable product (MVP) pilot.
In any of these situations, you’ll eventually need an accounting system – and in fast-growing SaaS companies, it’s especially important to start out with an accounting system that will scale with the business.
SaaS Accounting Standards
Accounting standards in the United States are set by the Financial Accounting Standards Board (FASB). These standards are generally referred to as Generally Accepted Accounting Principles (GAAP).
While not all companies necessarily need to follow GAAP, having GAAP-compliant financial reporting makes financial analysis of your company easier for multiple groups, including banks, outside investors, and competitors.
Companies that are publicly traded, or that have to follow certain government regulatory standards, have to follow GAAP standards for their financial reporting.
If your company is privately held, you are not required to follow GAAP standards. However, many privately held companies choose to follow GAAP reporting requirements anyway, for any number of reasons.
Some just like the consistency and transparency that GAAP brings. Others might be in business with a goal of an IPO, and want to establish the right accounting habits early.
ASC 606 is one of the most important updates to GAAP and its international equivalent, IFRS. Mandated in 2018, it lays out 5 key steps to accurately recognizing revenue to help clarify certain revenue recognition scenarios.
The five revenue recognition steps of ASC 606 are:
- Identify customer contract
- Determine performance obligation
- Define transaction price
- Allocate the transaction price
- Recognize revenue
These five steps can help companies decide whether certain revenues should be recognized all at once in a period or spread over time. It can also help clarify whether revenues should be recognized together under one contract or performance obligation, or whether they should be recognized as separate income streams to the company.
For more on ASC 606 scenarios in SaaS, see my companion article on revenue recognition in SaaS.
What Makes SaaS Accounting Different?
There are a few key differences between SaaS companies and other business models that make SaaS accounting unique from other companies.
The biggest difference between SaaS companies and other online businesses is how cash flow is structured and timed.
The subscription model means fairly consistent income throughout the year, but cash receipts that may vary wildly from month to month. Companies that have a larger proportion of monthly subscribers may see more consistent cash receipts throughout the year than those that have more annual or multi-year client contracts.
In either scenario, the success or failure of the business depends on the willingness of customers to make recurring purchases over time, rather than a one-time purchase.
The differences between income and cash receipts can be seen on the income statement and statement of cash flows. Everything should mostly even out on an annual basis, but quarterly or monthly statements may see large variations.
Low expenses and high gross margin ratios (relatively)
The low gross margin is what has made SaaS companies so popular and easy to scale.
Since there is no physical product, most of the cost comes from hosting, website and product development, and marketing. Hosting and development costs, while initially large, start to decrease in relative magnitude as the company grows, leading to much larger profit margins than other industries with manufacturing and inventory costs.
While the company will still have other expenses like leases, equipment, and employee wages as it grows, these will not be tied directly to growth, leading to higher profit margins industry-wide.
As an example, many SaaS businesses have 80%+ gross margins and 40%+ EBITDA margins.
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Kinds of SaaS Accounting
There are two main methods of recognizing revenue in SaaS for accounting: cash-basis and accrual-basis.
Cash basis is easiest to understand and maintain for business owners who may not like math/accounting, but accrual basis generally gives a more accurate picture of the company’s financial position over time.
Cash-basis accounting records all income and expenses of the business as the cash comes in and goes out.
This method can work well for small business owners with regularly recurring expenses and traditional pricing models, but can lead to wildly fluctuating profits or losses month-over-month for SaaS companies.
For example, suppose the company received $120,000 in January from 10 customers for annual subscriptions. This was recorded as income for the month. The only expenses paid in January were $10,000 in marketing costs, for a total profit in January of $110,000.
Then, in February, the company paid $4,000 for 3 months’ web hosting, and received $3,000 in new subscription revenue. February then showed a loss of $1,000.
While this is a very simplified example, you can see how cash-basis accounting distorts a company’s true earnings.
Many of these incomes and expenses should have been spread over their full lifetime with the company to truly reflect the company’s activities and transactions.
Accrual-basis accounting recognizes revenue not as it is received, but as it is earned by the company. Similarly, expenses are recognized as they are incurred, and not necessarily as they are paid.
This means that the company has to have some extra accounts for both income and expenses. For revenue, Accounts Receivable is needed to record revenue earned but not yet received, and Unearned Revenue is needed to record revenue received but not yet earned.
For expenses, the company’s bookkeeping needs Prepaid Expenses to record expenses paid but not yet incurred, and Accounts Payable to record expenses incurred but not yet paid.
Under accrual accounting, the company from our previous example would record the same transactions as follows:
In January, the annual subscriptions would be divided into $10,000 for January revenue, and $110,000 for Unearned Revenue that would be spread over the other 11 months of the year.
The marketing expense would be either fully expensed in January, if all the contractual obligations for the payment took place in January, or would be spread over several month’s worth of marketing efforts. In February, ? of the $4,000 in web hosting would be expensed in that month, while the remaining amount would be recorded in Prepaid Marketing Expense.
Accrual basis accounting, while more time and math-intensive, allows companies to tie revenue and expenses directly to the company’s activities that month.
GAAP Financial Statements and SaaS Metrics
While many key SaaS metrics and KPI’s are not reported in financial statements, many key metrics can be pulled from financial statements.
This makes it easy to evaluate key pieces of data from not only your own company, but your competitors as well.
It may be difficult to get information like customer lifetime value or the magic number about your competitors, but you can calculate some quick ratios on their performance from information in the annual report.
GAAP accounting requires three main financial statements: an income statement, a balance sheet, and a statement of cash flows.
The income statement shows the revenues and expenses for the period. The balance sheet shows a “snapshot” of the company’s worth and net holdings at the end of the period. The cash flow statement shows how well the company is managing its cash inflows and outflows as compared to accrual income for the period.
With financial statements in hand and an eye for the right figures, you can discern some key metrics about the health of your company (or someone else’s):
In accrual-basis accounting, annual and monthly GAAP revenue will track closely (though not exactly) with ARR or MRR.
This is because the value of an annual contract is spread over the entire year for income due to the revenue recognition principle.
Annual GAAP revenue will track closely with ARR over the entire year, and MRR will be very similar to the amount of GAAP revenue recognized each month.
Due to churn and customer upgrades and downgrades during the year, there will be slight variations. For the most part, though, these metrics are similar enough that they can be used interchangeably in quick financial ratio calculations.
The gross margin is the percentage of each dollar that goes to profit in each sale, after taking into account the cost of goods sold (COGS).
If the company has $1M of sales in a year, and $250,000 in COGS expenses, then the company has a 75% gross margin. This means that for every new dollar of revenue brought in, 75 cents of it is gross profit to the company.
This is useful in many SaaS metrics, especially months to recover CAC.
Bookings, billings, and revenue can often be confused with each other.
Bookings are a measure of how many new customers have signed up for a subscription, whether or not they have paid yet.
New customers who may still be on a free trial can be counted as bookings, but since they have not yet been billed, they are still a high churn risk.
Billings are the revenue that has been billed to customers that has not yet been collected. In accounting terms, this is the amount sitting in accounts receivable. For best health, the company needs two things:
- Bookings that tie closely to billings – this means customers are staying with the company
- Strong accounts receivable collections – this means customers are actually paying their accounts on time. Accrual revenue then can tie closely to actual cash received and the company will be less likely run into cash shortfalls
Finally, churn needs to be low. A revolving door of customers is not a sustainable business model for SaaS companies. This leads to low customer lifetime values, higher customer acquisition costs, and higher overall expenses.
Maintaining a high net revenue retention rate and low churn rate is one of the most straightforward (if not easy) ways for SaaS companies to improve metrics across the board.