The software as a service (SaaS) business model has taken off, with more and more startups choosing to offer the use of their proprietary software for a subscription fee. While this model can be a profitable one, it comes with many accounting challenges that must be addressed.
In this guide, you’ll learn the basics of SaaS accounting and how to handle its challenges.
In a SaaS model under GAAP rules, revenue is recognized, meaning that it’s accounted for, when services are delivered. For example, if you sign a contract with a customer, the revenue cannot be recognized until the customer has access to your software. Even if they have yet to pay for any given month, if they have access to your software, you can recognize the revenue.
This rule comes from the introduction of rule ASC 606, which is a five step revenue recognition process.
- Identify the contract, whether written or verbal
- Identify any separate performance requirements of the contract
- Determine the price for the transaction
- Allocate the price between the separate performance requirements of the contract
- Recognize the revenue for each performance requirement when that specific obligation has been filled, meaning that the service has been performed.
When you recognize the revenue but it has yet to be paid, you’ll record the revenue, as well as the unpaid bill as accounts receivable.
Revenue is important to track, as it’s the true measure of your company’s performance. You should track your revenue’s growth over time to ensure that your company is growing at your projected rate. You can use an online revenue growth calculator to do so.
A SaaS model business has many costs to account for, including cost of goods sold (COGS). For a SaaS business, the COGS are the costs to build and run the software, which include hosting costs and the cost of software maintenance and enhancements. Anything unrelated to these processes are not included in COGS.
A common mistake made by SaaS companies is including company operating expenses in COGS, but this will not give you a clear picture of your gross profit margin, which is an important number to monitor.
Your gross margin is your revenue minus COGS divided by your revenue. Gross margins for a SaaS company are typically high, at least 70%. You need to know your true gross margin so that you know if you’re meeting industry standard gross margins. If you’re not, you’ll need to analyze your costs and prices to see if you need to make adjustments.
Other costs for a SaaS company include overhead, customer service costs, and sales and marketing expenses. You’ll need to account for all these expenses to get to your net profit and your net profit margin.
One of the key challenges of accounting in a SaaS model is subscription management. You can be acquiring new subscription accounts at any given time, and having cancellations as well. You need to have a system to manage your accounts and to bill your customers as these subscription changes occur.
This system should integrate with your accounting software so that you recognize revenue correctly when subscriptions start or stop.
Sales tax requirements for a SaaS company are, of course, complicated. Each state has different rules regarding the tax on a SaaS service. However, if you’re selling your software subscription to a person or company in a state in which SaaS products are taxable, you only have to collect and pay sales tax if you have an “nexus” with that state. Generally, you have a nexus if your business has a physical connection to that state, or if you have an economic nexus with that state.
An economic nexus is when your business receives a substantial amount of revenue from that state, which is defined differently in every state.
To collect and pay sales tax in any given state, you’ll need to obtain a sales tax permit in that state.
If you’re selling internationally, you’ll have to follow the sales tax rules in each location where you have subscribers.
Per GAAP rules, you must generate three financial statements as a part of your accounting process.
- Income statement – Revenue less expenses to equal net profit
- Balance sheet – Assets less liabilities to equal shareholder’s equity
- Cash statement – Cash coming in less cash going out to equal cash on hand at any given time
These statements will allow you to track certain key performance indicators that can give you information about the health and growth of your company.
Key Performance Indicators for a SaaS Company
Two key performance indicators (KPIs) are most important for a SaaS company to track.
- Churn Rate – Your churn rate is the rate that tells you the percentage of customers that are cancelling. It’s calculated by dividing the users who cancelled during the month by the number of users that you had at the beginning of the month. For example, if you had 10 customers cancel during the month and you started the month with 100 users, your churn rate is 10%. You need to know this number so that if its high or increasing, you can take measures to improve it.
- Monthly Recurring Revenue – This simply means the amount that you’re collecting on a monthly basis from your subscribers. You’ll monitor this number over time to see how your business is growing.
These are not the only KPIs to track but they are the most critical:
You’ll also want to track:
- Gross profit margin
- Net profit margin
- Customer acquisition cost
- Website conversion rate
- Customer lifetime value
Accounting Software for SaaS
Clearly, accounting in a SaaS business is not easy. Unless you’re an accounting pro, you’ll need accounting software to help you. There are many SaaS specific software options that can make your life much easier.
Features to look for include:
- MRR reporting
- Subscription billing
- Cash flow forecasting
- Payment system integrations
- CRM integrations
- Unlimited transactions
Tackling the challenges of SaaS accounting may seem monumental, but accounting software can simplify the process. Alternatively, you could outsource the services of an accountant who has experience in the SaaS industry. In any case, you want your accounting to be accurate so that you can measure the success of your company over time, and so that you’re following all regulations and tax laws.