Accounting For SaaS Businesses - A Guide For Founders

So what makes SaaS accounting different from traditional accounting?

Why can’t we just slap on the old traditional accounting methods and call it a day? 

Well, there are two sides to this coin: the functional and the regulatory.

Functional Differences

First up, let’s talk about how SaaS businesses operate. Example: you’re running a SaaS company with a whole bunch of pricing models—subscription plans, usage-based pricing, free trials, you name it. 

It’s like running a restaurant that serves everything from fast food to gourmet meals, and your accounting system has to keep track of it all without getting confused.

Traditional businesses have it easier because they sell a product and then record the sale. 

But in the SaaS world, you’ve got to figure out how to recognize revenue over time. 

Do you record it all upfront? 

Or do you spread it out over the life of the subscription? 

Regulatory Differences

How SaaS companies are regulated is also an important factor to consider, especially when it comes to the FASB and IFRS. 

Institutions that have created regulations that are tailor-made for the SaaS industry.

Basically: if your company checks off these three boxes, you’re officially a SaaS business in the eyes of accountants:

1. You own the software.
2. Customers can’t run the software on their own or a third party’s hardware.
3. Your team administers the software services

If you meet all these criteria, you’ve got to follow the SaaS-specific accounting rules.

1. Why is Detailed SaaS Accounting Important?

If you want to get funding, this is one of the first things they’ll look at.

Let’s face it: you need cash to grow, and investors are the gatekeepers. 

They’ll want to see your financial records looking like a well-organized spreadsheet, not a chaotic mess. 

If your numbers are more like a guessing game, investors will walk away faster than you can say “venture capital.”

Tax Considerations

SaaS businesses face a unique set of tax obligations due to the nature of their offerings. 

These obligations can vary significantly based on jurisdiction, the nature of the transactions, and the location of the customers. 

Some important tax obligations for SaaS businesses include:

1. Income Tax: Like any other business, SaaS companies are required to pay corporate income tax on their profits. The specific rate and regulations depend on the country of incorporation and operation.
2. Sales Tax/VAT: This is one of the most complex areas for SaaS businesses as they often have a global customer base. The rules can differ significantly from one jurisdiction to another.
3. Withholding Tax: This tax is typically levied on cross-border payments. Depending on international tax treaties, the rates and requirements may vary.
4. Employment Taxes: If the SaaS business has employees, it needs to comply with payroll tax obligations, including social security, unemployment, and other employee-related taxes.

If we go into this in more detail, here are some key factors you have to be aware of:

1. Sales Tax:
• In the United States, the obligation to collect sales tax on SaaS products depends on state laws. Some states classify SaaS as taxable tangible property, while others do not.
• Sales tax rates and nexus rules (the connection that must exist for a state to impose tax collection obligations) can vary quite widely.
2. Value-Added Tax (VAT):
• In theEU, SaaS services are generally subject to VAT. The place of supply for VAT purposes is often the customer's location, which means SaaS providers must register for VAT in each EU country where they have customers.
• VAT rates differ from country to country, and businesses may need to deal with the Mini One Stop Shop (MOSS) scheme to simplify compliance.
3. Goods and Services Tax (GST):
• Countries like Australia, New Zealand, and Canada impose GST on digital products and services, including SaaS.
• SaaS businesses must register for GST and comply with local filing requirements.
4. Other Relevant Taxes:
• Excise Taxes: Some jurisdictions might impose excise taxes on specific digital services.
• State and Local Taxes: In addition to federal taxes, SaaS businesses must be aware of state and local tax obligations.

So how can you stay compliant? Here are some steps:

1. Understand the Nexus Rules: Determine where your business has a tax obligation by understanding the nexus rules in different jurisdictions. Nexus can be created through physical presence, employees, or significant sales.
2. Register for Taxes Where Required: Ensure that your business is registered for VAT, GST, sales tax, or other relevant taxes in the jurisdictions where it has an obligation.
3. Maintain Accurate Records: Keep detailed and accurate records of all transactions, customer locations, and tax collected. This will help with compliance and audits.
4. Automate Tax Collection: Use software solutions that automate the calculation, collection, and remittance of taxes. This can reduce the risk of errors and ensure compliance.
5. Regularly Review Tax Laws: Tax regulations for SaaS and digital services are constantly evolving. Stay informed about changes in tax laws in the jurisdictions where you operate.

Given the complexity and variability of tax obligations for SaaS businesses, we highly recommend getting a tax professional who understands your business and jurisdiction.

2. Key Elements of SaaS Accounting

Good SaaS accounting is like a well-oiled machine, with each part playing a critical role. 

Let’s look at some of the key components:

GAAP Compliance

SaaS companies must adhere to the Generally Accepted Accounting Principles (GAAP). 

This isn’t just a formality; it’s a must for transparent and standardized financial reporting. 

This includes:

• Profit & Loss (P&L) or Income Statement: Which details all income earned and expenses incurred over a specific period, giving you a clear view of your operational performance.
• Balance Sheet: This provides a snapshot of your company’s financial health at the end of a period, listing assets, liabilities, and equity.
• Cash Flow Statement: This tracks all cash inflows and outflows during a period, showing how well your company manages its cash to fund operations and growth.

Accounting Methods for SaaS

When it comes to accounting methods, SaaS companies typically choose between two approaches:

1. Cash-Basis: Which means that revenue and expenses are recorded when cash is actually received or paid out. It’s straightforward and simple but may not give a full picture of your financial health.
2. Accrual-Basis: This method records revenue and expenses when they are incurred, regardless of when cash changes hands. It provides a more accurate and predictive view of your financial situation.

For most SaaS companies, accrual-basis accounting is the preferred method. 

It aligns better with the way SaaS businesses operate, recognizing income when a service is provided rather than when payment is received. 

This method is also required by the IRS for companies with average gross revenues exceeding $25 million.

Using the accrual method helps in better financial planning and analysis, making it easier to match revenues with the expenses incurred to generate them. .

3. Accounting Metrics & KPIs

So let’s take a look at some essential SaaS metrics and KPIs that will keep your business sailing smoothly. 

These numbers aren't just figures—they're the factors that give you more insights into your business and drive your decisions and growth.

A brief overview of some SaaS metrics to pay attention to for accounting purposes:

1. Bookings: This is the total value of all the contracts you’ve signed in a given period. It’s like a scoreboard for future revenue. If you closed a $10,000 annual contract today, that’s $10,000 in bookings.
2. Billings: Unlike bookings, billings are the actual invoices you’ve sent to customers during a period. For instance, if you bill $1,000 per month to a customer, each month’s billing adds $1,000 to this metric.
3. MRR (Monthly Recurring Revenue): This is the predictable monthly income you get from subscriptions. 
4. ARR (Annual Recurring Revenue): Scale up MRR to an annual perspective. This is a great way to gauge long-term financial health.
5. COGS (Cost of Goods Sold): This metric includes all the direct costs associated with delivering your service, like hosting fees, customer support, and software development. If your COGS is $2,000 and your revenue is $5,000, you’re on the right track.
6. Gross Margin: Calculated as (Revenue - COGS) / Revenue. It tells you how much profit you’re making after covering direct costs. If your revenue is $5,000 and COGS is $2,000, your gross margin is 60%. The higher, the better.
7. Churn Rate: The percentage of customers who cancel their subscription in a given period. Keeping this low is crucial for growth.

If you want more details on which SaaS metrics to measure, check out this blog post.

4. Revenue Recognition

The tricky part when it comes to SaaS accounting is revenue recognition. This is basically comes down to when you can actually count your revenue. 

Unfortunately, it’s not always when you get paid.

SaaS companies often deal with different types of revenue such as:

1. Accrued Revenue: Revenue you’ve earned but haven’t yet collected. Imagine a customer using your service now but paying later. You’ve earned it, but the cash isn’t in your pocket yet.
2. Unearned Revenue: Also known as deferred revenue, this is cash you’ve received but haven’t earned. For example, a customer pays upfront for a year, but you still need to provide 12 months of service. Each month, a portion of that payment moves from unearned to earned revenue.
3. Earned Revenue: This is revenue you’ve both earned and collected. It’s when you’ve provided the service and got paid—simple as that.

Why is this important? 

Because recognizing revenue correctly ensures your financial statements are accurate, reflecting the true health of your business. 

Missteps here can lead to overestimating your success or, worse, running afoul of regulatory bodies like the Financial Accounting Standards Board (FASB)

Some practical tips for this:

1. Stay Consistent: Use the same methods and metrics consistently. This helps you track performance over time accurately.
2. Automate: Use accounting software that integrates with your CRM and billing systems. Tools like QuickBooks, Xero, or specialized SaaS accounting platforms can save time and reduce errors.
3. Consult the Pros: Having a good accountant who understands SaaS is like having a good mechanic for your car. They’ll keep everything running smoothly and ensure you’re compliant with all regulations.

5. Expense Management

Managing expenses in a SaaS business is super important for maintaining financial health and making informed decisions, especially if you're bootstrapped.

Here are some of the most common expenses that SaaS companies have:

1. Research & Development (R&D)
• This is the core of a SaaS company. Investing in R&D ensures your product stays innovative and competitive. It includes salaries for developers, costs of testing, and tools for continuous integration and deployment.
2. Customer Support
• Happy customers are essential. Expenses here include support staff salaries, helpdesk software, training programs, and any outsourced support services.
3. Marketing
• To attract and retain customers, you need to invest in marketing. This covers digital marketing (SEO, PPC, social media), content creation, partnerships, and events or webinars.
4. Sales
• This includes salaries for your sales team, commissions, CRM tools, and any travel or accommodation for in-person meetings or conferences.
5. Operations
• These are the costs that keep your business running smoothly: office rent, utilities, administrative salaries, and office supplies.
6. IT and Infrastructure
• Hosting, cloud services, cybersecurity, and all the technical support that keeps your SaaS product up and running.

Pro tip - if you're using a lot of different software tools, sooner or later you'll end up with tools you're not using but still spending money on each month.

Using a SaaS expense management tool like NachoNacho can help minimize money wasted on redundant software tools and cut your expenses.

Tips for managing cash flow effectively

1. Forecasting: Regularly update your cash flow forecasts to anticipate future needs and avoid surprises.
2. Expense Reviews: Conduct monthly or quarterly reviews to ensure you're staying on budget and to identify any unnecessary expenses.
3. Vendor Negotiations: Negotiate with your vendors for better terms or discounts, especially for recurring services.
4. Automate Payments: Use automated tools to manage invoices and payments to avoid late fees and streamline the process.
5. Monitor Receivables: Keep an eye on your accounts receivable to ensure clients are paying on time. Consider offering incentives for early payments.

Accounting software tools for SaaS you can use to help manage your expense:

1. Expensify: A decent tool for tracking expenses, managing receipts, and submitting expense reports. Great for keeping everything organized and easy to access.
2. QuickBooks: Popular among small to medium-sized businesses, it offers comprehensive features for tracking expenses, invoicing, and financial reporting.
3. Xero: Known for its user-friendly interface, Xero helps with expense tracking, bank reconciliation, and even integrates with various other business tools.
4. Paddle: This billing platform makes it easy to manage subscription payments and automatically adds any relevant taxes, saving you a lot of time and hassle if you're selling internationally.
5. Wave: Perfect for small businesses, Wave offers free accounting software that includes expense tracking, invoicing, and receipt scanning.

6. ASC 606: Understanding Revenue Recognition for SaaS

When ASC 606 was rolled out, the main idea was to bring some order to the chaos of financial reporting, especially for companies with long-winded contracts with customers. 

This is not just for SaaS businesses—any company with long-term customer deals has to do this.

ASC 606 has five main principles for recognizing revenue. Let’s break them down, using an example of an imaginary SaaS company that just landed a $100,000 contract for a year.

1. Identifying the Contract

First thing you have to do is set down a legitimate contract. 

This means that  both you and your customer know and agree on the terms, especially the financial part. 

Everyone should know their roles and responsibilities, and it has to be written down specifically.

2. Identifying Performance Obligations

For most SaaS businesses, this is pretty straightforward—you provide the software as promised. 

Sometimes, you might have extra stuff like setup help or training. 

Whatever the deal is, these performance obligations need to be clear so the customer gets the full benefit of what they’re paying for. 

Typically, this means you recognize revenue monthly since your customers are using your software every month.

3. Determining Transaction Price

Here’s the fun part—figuring out how much you’re going to get paid. 

In our example, your sales team has sealed a $100,000 deal for the year. 

So that’s the transaction price.

4. Allocating the Transaction Price

Next, you need to divide up that $100,000 across your performance obligations. 

If you’re fulfilling obligations monthly, you split it up evenly. 

For a year-long contract, that means 8.33% of the total contract value goes to each month.

5. Recognizing Revenue as Performance Obligations Are Met

Finally, as you meet your performance obligations, you can officially recognize the revenue. 

So, in our example, you’d recognize $8,333.33 each month in your financial statements, as long as you’re keeping up your end of the bargain as outlined in the contract.

This is the simplified basics of ASC 606, just to give you an idea. There are some great articles on this if you need more information. 

Conclusion

Accounting for SaaS businesses can feel like an intricate puzzle, but with the right knowledge and tools, it becomes a manageable and even rewarding endeavor. 

In this post, we've covered the essential aspects that founders need to grasp to ensure their business's financial health and compliance.

Firstly you need to understand the functional and regulatory differences that set SaaS accounting apart. After that, it’s important to look at the tax considerations in SaaS.

This can be particularly complex due to the nature of digital services and varying regulations across jurisdictions especially when it comes to sales tax and VAT.

Key elements of SaaS accounting include ensuring GAAP compliance, which provides a standardized framework for financial reporting. 

Different accounting methods, such as cash and accrual accounting, offer varied insights, with accrual accounting often being preferred for its comprehensive reflection of financial performance.

We also looked at some important metrics and KPIs like Monthly Recurring Revenue (MRR) and Customer Lifetime Value (CLTV) that you have to pay attention to when it comes to your accounting.

Revenue recognition, governed by ASC 606, is another important area. This standard guides how and when revenue is recorded, ensuring that financial statements accurately reflect the company’s performance. 

The five-step model of ASC 606 — identifying the contract, identifying performance obligations, determining the transaction price, allocating the transaction price, and recognizing revenue — provides a clear roadmap for compliance.

Some practical things to do when it comes to expense and cash flow management are: forecasting cash flow, managing expenses diligently, and leveraging software tools for automation..

Lastly, we looked at some software tools to make accounting a bit easier. These include tools that can track expenses, ensure compliance, and provide real-time financial insights. 

The advantage of using these tools is that they can automate routine tasks, reduce errors, and free up time for strategic activities.

In conclusion, while SaaS accounting may seem daunting at first, it is a critical component of running a successful business. By understanding and implementing best practices in accounting, founders can gain deeper insights into their business, ensure regulatory compliance, and position their company for sustainable growth. 

Remember, the right accounting approach not only keeps your books in order but can also help you to make data-driven decisions that grow your business.