Every startup that wants to grow sustainably and legally needs to take care of accounting from day one.
Implementing the right system and providing transparent reports can earn you more investments and foster reliable business relationships.
A transparent accounting system also guarantees compliance with tax regulations. This should be a priority, since failing to comply with them from day one can be very detrimental to your business.
However, financial jargon can be confusing.
It is often even more complicated for SaaS companies because standard accounting rules often don’t apply in this business model.
To help out, we’ve compiled a guide for every relevant term you need to know.
Read on and take control of your accounting!
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Accounting means keeping track of the company’s revenue and financial operations.
In a nutshell, having a clear insight into how much money flows in and out of your bank account is vitally important to keep any business running.
For SaaS, this is even more important because while recurring revenue is one of the main benefits of this business model, it can also fluctuate greatly.
Customers churn daily, the acquisition process is nuanced and expensive, and you have to keep track of everything under the sun to make smart decisions.
For startups, clear and up-to-date financial records often mean all the difference when it comes to raising necessary funds from venture capitalists or banks.
You also need to submit financial statements when you’re paying federal taxes, and to prevent any tax violations or surprise bills.
Therefore, once you set up a bank account, find a reliable accountant as well.
An excellent accounting system will set you up for success and support your business.
When you first start, keeping track of your income might be easy, but if you want to grow, it’s essential to have an accounting solution that will keep your cash flow in check and guarantee compliance with IRS regulations.
SaaS is a subscription-based business, and that makes accounting slightly more challenging.
Customers pay their subscription fees, but there can be added charges for extra benefits, as well as downgrades and upgrades.
Those changes can happen daily or monthly, making the recurring revenue less predictable than you’d like.
Moreover, cloud-based solutions require a different set of tools that allow for easier accounting.
The most widely used ones are subscription management and billing software. Such solutions, like the billing system provided by Regpack, are often highly intuitive and therefore easy to use.
Aside from complex cash flow dynamics, SaaS businesses also have to consider the cost of other key business elements, such as marketing and sales, hosting fees, and maintenance.
While their production costs are pretty low, SaaS businesses allocate resources to departments surrounding the product.
There is another thing that often becomes challenging as a SaaS business grows: high gross margins.
High gross margins represent the profit of the company or the amount of money left over after the operational costs are covered.
For SaaS, it’s usually between 60-70%.
So, when there’s more money involved, keeping track of it becomes more complex.
SaaS businesses need to pay closer attention to their accounting than other businesses because of the complex revenue streams and the uniqueness of their business model.
The main question in accounting is which method to use.
There are two approaches you can choose from, and they differ according to the timing of financial transactions.
Cash-based accounting recognizes revenue once you spend or receive money.
It’s a straightforward method and simple to use.
Transactions are not recorded until they appear in a bank account and are taxed after that.
For example, when someone buys candy, they give you money for it, and that’s the profit you’ve gained from that sale.
With this method, it’s easier to determine when a transaction has happened and track how much money the business currently has.
It’s an excellent method for startups in the early stages of development and very small businesses.
However, once the company grows, the complexity increases—especially if you offer different price tiers and discounts.
This method also doesn’t recognize credit purchases and installment payments.
Another drawback to cash-based accounting is that it’s challenging to forecast and thus the unwanted method of providing financial status reports to potential investors.
Because of the complexity of the SaaS business model, using cash-based methods is usually discouraged.
Instead, it is more advisable for SaaS companies and to use accrual accounting.
Accrual Accounting for SaaS
Accrual accounting tracks revenue and expenses when they are earned but not paid.
SaaS is a complex business model that includes advanced payments and tier pricing changes. Accrual accounting tracks revenues and expenses, so it can be used to track MRR, too.
In accrual accounting, you keep records of contracts, provided service and orders, and when you receive the money doesn’t matter.
Keep in mind that there is a difference between transaction and payment.
A transaction is a closed loop of providing a service and receiving money, whereas a payment only entails receiving the money, and not the act of providing the service.
That distinction is especially crucial for SaaS business models because payments are made upfront, but service is provided over time.
Accrual accounting covers your revenue and expected expenses more accurately.
The benefits of this method include a more accurate overview of the company’s profit and a better future revenue forecast.
Some of the cons involve more complex bookkeeping and paying taxes on money that hasn’t yet been received—because the sale has already been reported.
This method is more beneficial to large and growing companies’ subscription-based services and, according to the IRS, it’s a requirement if your business earns more than $25 million.
Accrual accounting reports all your revenue and expenses so you can plan for future growth.
Recording transactions is another way of saying bookkeeping.
We’ve already explained why it’s important and here are several metrics you should keep in mind in order to demonstrate the financial health of your business.
Bookings refer to when a customer signs up for your subscription plan. Users agree to spend money with you for the duration of the plan or until they cancel.
This metric is a great way to show the demand for your product and how much value your customers get from your product. Startups can determine the product-market fit by looking at bookings.
You measure bookings by looking at the total amount of money pledged to your company in a specific month.
There are various types of bookings you can measure, like new bookings, renewals, and upgrades. Companies with annual plans have annual bookings.
You have to take into consideration the entire length of the subscription plan your customers signed up for.
Also, there are other non-recurring bookings such as set-up fees and discounts.
It is helpful for sales teams to analyze which subscription plans draw more attention and adjust their acquisitions strategy.
Bookings are essentially an indicator of sales growth and can be used as a metric for sales success.
Nevertheless, bookings should be used as a projection metric and not an accurate assessment of your cash flow.
You simply measure your customers’ commitment to your service.
However, bookings are not revenue and should not be calculated towards MRR or ARR.
While bookings don’t directly impact your financial reports, they are a great indicator of market demand and your product’s value in the customer’s eye.
Billings indicate the amount of money you collect from your customers.
Money can be collected at any time when you’re doing business—upfront, monthly, or after a specific period.
They are a valuable metric to show the health of your business. You can see how much money you’ll collect in each period.
Billings can show you the state of your cash flow and indicate issues in that area.
Sometimes your bookings may be high, but your billings won’t be on the same level, for instance, due to poor service.
This problem can occur when there’s no upfront billing.
So, for example, if your customer signs up for a $1200 annual plan paid monthly and they churn at the six-month mark, instead of collecting on a $1200 bill, you’ll be getting $600.
Many SaaS companies have opted for upfront billing or an overall increase in billings to fix those problems.
Another way to increase your income is to convert monthly plans into annual contracts with discounts. Getting money upfront can help you jump-start growth.
Use billings as an indicator of the actual cash flow in your business.
Use a reliable billing system for your SaaS to generate accurate reports of your earnings.
Revenue is the income you earn after you provide services to your customers.
In SaaS, revenue is recognized over the lifetime of an active subscription plan. This is generally known as revenue recognition.
While you might get cash upfront, it isn’t truly yours until you’ve provided the desired service.
Here is a visual example of how revenue works.
If you have monthly plans, you can count into your revenue the amount you earn each month after providing service.
This is aligned with GAAP rules because an income can only be recognized once it’s “earned.”
Until you earn the money your customer has paid you—either upfront or in monthly installments—the revenue that’s left is called deferred revenue.
At any point during their subscription plan, your customer can ask for their money back, so you mustn’t immediately count your deferred revenue as part of your overall revenue as it could mess up your metrics.
Bookings and billings can show you overarching numbers, but you should track the actual revenue that you get from the customers’ plans.
Revenue works with the other two metrics to show if KPI and goals are met with projections made by bookings and billings. It can also help in measuring MRR and ARR.
Every contract starts as unearned revenue, but it is gradually recognized as contracts get renewed.
GAAP stands for Generally Accepted Accounting Principles, and it is a set of rules and regulations to standardize accounting methods in the world.
Accounting standards are used for transparency and consistency in financial reporting for every organization.
Using GAAP enables companies to accurately track their financial activity and use them to make informed decisions about their future investments.
On the other hand, investors often use GAAP to evaluate a company’s finances and the value of its investments.
Under GAAP’s guidelines, there are several reports your company needs to make to declare its financial status.
Income Statement tracks all of the information about your business.
When you create your income statement, stick to three main categories: revenue, expenses, and profit.
Revenue refers to sales accumulated in a certain period. The only type of revenue tracked is recorded revenue.
So, for example, if you have a customer with an annual plan of $120 but track a six-month period, you will only recognize the $60 for that period rather than the full amount your customer paid you.
Another thing to include in your income statement is COGS or Cost of Goods Sold.
In SaaS, this is referred to as COR or Cost of Revenue—since SaaS doesn’t have a physical product, the costs need to be recorded differently.
The direct costs for SaaS include:
- hosting and infrastructure
- cloud operations
- third-party data fees
- customer support.
Revenue and costs need to be organized separately for better financial analysis. It’s also useful for benchmarking and comparison within the industry.
And finally, when you subtract your revenue from your costs, you can provide a line in your income statement about your profit.
Cash Flow Statement
A cash flow statement is a report on how a business manages cash for its operations. It tracks the amounts of money that enter and leave the company.
This financial statement is helpful for investors and creditors to understand how companies handle their expenses, income, and debt payment.
This report is different from the income statement in that it doesn’t include future credit income and the sales made on credit.
Read more: SaaS Finance Mistakes in Growing Startups
To write a good cash flow statement, you need to include the operating, investing, and financing activities.
Cash flow examines the total cash used and generated to fund business activities.
A balance sheet lists all the assets owned by a company at a particular point in time, as well as its liabilities, and equity.
In other words, it is a report on the state of the company’s finances at a specific point in time.
It’s an easy way to show how much a company owns and owes, and is generally used to evaluate a company’s capital structure.
A simple formula to learn how to use a balance sheet is this:
Assets = Liabilities + Equity
Assets include the company’s cash and the property for which it needs to pay through liabilities (rent, taxes, loans, etc.).
Equity is the value of the company. It includes investments from shareholders and operating gains.
This is merely a snapshot of the company’s financial standing in a specific period, and it cannot be used for informative decision-making about its future.
It can serve as a comparison method but also as proof of financial stability.
Once you know how SaaS accounting is different from the traditional ways, you can better understand and analyze your cash flow.
Track important metrics such as bookings, billings, and recognized revenue to have a clear view of your company’s financial health.
Also, to comply with standardized guidelines, provide investors and creditors your income and cash flow statements and balance sheets.
Doing all that will enable you to control your company’s finances and make smart decisions about the future of your business.