There isn’t a specific set of SaaS accounting standards to follow. SaaS businesses use the same generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS), depending on their location. However, we find some specific considerations when applying these standards to the SaaS business model. In this post, we’ll go over these along with other factors that pertain to recording and reporting financial activities.
What is SaaS Accounting?
While the general principles of accounting are the same, SaaS accounting is a specialized form of financial management and accounting practices tailored to SaaS companies.
SaaS companies operate on a subscription model, which means they receive payments upfront (i.e., deferred revenue) for their services, and revenue needs to be recognized monthly or as the service is delivered (i.e., accrued revenue), not only when the payment is received.
Unlike traditional accounting, where income statements and balance sheets are enough to measure performance, SaaS needs metrics like MRR, ARR, CLTV, and churn rate.
SaaS accounting ensures that the revenue, expenses, and metrics are tracked and reported in alignment with accounting standards like ASC 606 (U.S.) or IFRS 15 (International), which govern revenue recognition for contracts.
The Basics of SaaS Accounting Standards
First off, SaaS companies typically follow ASC 606 (US GAAP) or IFRS 15 for revenue recognition. These standards require you to recognize revenue over the subscription period as the service is delivered. This means that you report it even if you have not yet received payment.
This is different from traditional product sales, but similar to sales on credit. Since you recognize revenue over time, you record unearned customer payments on the balance sheet as deferred revenue. This represents the customer’s liability for the service not yet delivered.
SaaS companies usually track key metrics like Customer Acquisition Cost (CAC), Customer Lifetime Value (CLTV), and Monthly Recurring Revenue (MRR). You need to know these metrics for proper financial analysis and growth planning within the industry.
Why These Standards are Crucial
SaaS businesses don’t get a separate accounting rulebook, but understanding how to apply GAAP or IFRS to your business model is vital.
Adhering to SaaS accounting standards guarantees better accuracy and transparency in financial reporting. This ensures that your financial statements are more reliable for investors, creditors, and other stakeholders to make informed decisions. Accurate financial reporting builds confidence in potential investors. Following the accounting standards also ensures that you comply with regulations and avoid fines and penalties.
When you follow standardized practices, you also have a consistent framework to depend on. This way, you can benchmark your performance against industry averages and identify areas for improvement.
Accurate financial data underpins informed decision-making. Standards help you allocate resources effectively, set realistic goals, and track progress towards those goals. They also allow you to create accurate financial forecasts that will help you plan for future growth, manage cash flow effectively, and make strategic business decisions.
Beyond attracting investment, adherence to accounting standards makes your company more attractive for potential mergers and acquisitions. If your company plans to go public, you must comply with accounting standards to get listed on a stock exchange. Moreover, you minimize errors when you follow standardized accounting practices, which protects your company from potential legal repercussions.
Key SaaS Accounting Standards to Follow
Below, we explore the essential SaaS accounting standards every company should follow.
Revenue Recognition (ASC 606 / IFRS 15)
ASC 606 and IFRS 15 are international accounting standards. They dictate how your business recognizes revenue for contracts with customers. These standards aim to improve consistency and transparency in your financial reporting. This is especially true for companies whose contracts involve multiple goods or services delivered over time. This is very common for SaaS companies.
The core principle of ASC 606 / IFRS 15 is that your business recognizes revenue as it transfers control. This means when you hand over the promised goods or services to the customer. In other words, it happens when the customer has the ability to use or benefit from the good or service. At this point, the company is typically no longer obligated to perform further actions, unless ongoing service is part of the deal.
For this to happen, your business needs to either identify individual contracts or combine multiple contracts into a single contract for accounting purposes. Then you need to identify the performance obligations in the contract. You can only recognize revenue when you fulfill the promise of the distinct goods or services.
Next, you must determine the transaction price, which is the total amount that the customer must pay in exchange. Then you allocate the total price to each performance obligation based on its relative standalone selling price.
Your business then records unearned customer payments for undelivered services on the balance sheet as deferred revenue. This represents the customer’s liability for the service not yet delivered.
ASC 606 / IFRS 15 provides a few benefits to SaaS companies. First, you get improved comparability in financial statements and a clearer picture of how revenue is generated. This leads to more transparent financial reporting and better decision-making on pricing, resource allocation, and performance measurement.
Capitalization of Development Costs (ASC 350-40 / IAS 38)
ASC 350-40 and IAS 38 are accounting standards that dictate how companies capitalize. In other words, companies can expense the costs associated with developing intangible assets, such as software. These standards help ensure that companies only capitalize costs that are likely to generate future economic benefits.
The standard dictates that the development project must be expected to create an intangible asset. Furthermore, the asset must be identified and separated from the business. The company also needs to demonstrate the technical feasibility of completing the intangible asset to function as designed. The company furthermore needs to demonstrate a plan for the intangible asset to be used or sold. This must generate probable future economic benefits. This could mean evidence of a market for the asset, the ability to produce it for sale, and the necessary rights to use or sell it.
The costs incurred through all this must be directly attributable to the development of the intangible asset. This includes costs for materials, labor, and overhead that is directly related to the development process. The business must measure capitalized costs at their historical cost. This includes all expenditures incurred to bring the asset to its current location and condition.
Costs that are typically expensed under this standard include research costs, which are associated with general discovery activities. Internal costs are those associated with routine activities like employee salaries or administrative expenses. The business expenses costs that are not directly related or attributable to the development of the specific intangible asset as incurred.
Capitalization offers benefits like improved asset valuation through a more accurate representation of the company’s intangible assets. It also allows companies to match the costs of developing an intangible asset with the revenue it generates in the future.
Customer Contract Costs (ASC 340-40)
ASC 340-40 is an accounting standard issued by the Financial Accounting Standards Board (FASB) in the US. It deals with accounting for the costs associated with obtaining or fulfilling a customer contract. It outlines the criteria for recognizing these costs as an asset or an expense.
This standard focuses on incremental costs. This means the additional costs a company incurs specifically to obtain a customer contract that it would not have incurred otherwise. These costs can include sales commissions paid to employees, legal fees associated with negotiating the contract, and travel expenses directly related to securing the contract.
ASC 340-40 dictates whether incremental costs should be capitalized as an asset or expensed as incurred. Costs can be capitalized if you expect to recover them through future revenue generated from the contract. If capitalized, the costs are expensed systematically over the period the company benefits from the customer contract. You should align this amortization period with the pattern of revenue recognition from the contract.
Capitalizing and amortizing costs allows companies to match the expense of acquiring a customer with the related revenue generated over the contract life. This provides a more accurate representation of a company’s profitability. By separately identifying and accounting for customer contract costs, you can generate more informative financial statements for analysis purposes. Note that accurately estimating the amortization period for capitalized costs can be challenging, especially for complex contracts.
Financial Instruments (ASC 820 / IFRS 9)
ASC 820 and IFRS 9 are the accounting standards that govern how companies recognize, measure, and report financial instruments. These standards apply to a broad range of financial instruments. They include cash and cash equivalents, loans and receivables, debt securities, equity instruments, and derivatives.
A key aspect of the standards is classifying financial instruments based on their characteristics and how an entity manages them. You would measure financial instruments held for trading or with certain characteristics at fair value. You then recognize gains or losses in the current period’s profit or loss. Usually, you would measure debt instruments held to collect contractual cash flows at amortized cost.
The standards require companies to assess their financial instruments for impairment. This means a loss in the expected future cash flows from the instrument. If you can identify an impairment, you recognize a loss in the income statement.
Companies can use hedge accounting to offset the risks associated with certain financial instruments. This can help to reduce volatility in reported earnings.
These standards enhance transparency by requiring more detailed disclosures about financial instruments. This allows for a better understanding of a company’s financial position and risk profile. The focus on fair value and impairment encourages companies to actively manage their financial instrument risks. The standards also facilitate better comparability of financial statements across different companies through a consistent accounting framework.
Essential Accounting Methods for SaaS Companies
Accounting is a broader subject that has multiple specialized applications for different industries.
The internet holds numerous answers for accounting methods for SaaS companies, but if you are thinking about growing your business, there are only two primary methods: cash-basis accounting and accrual accounting.
In practice, most SaaS companies will use accrual accounting, which is compatible with the business’s complexity and recurring revenue model.
Let’s learn more about these two methods:
1. Cash Accounting
Cash accounting is the simplest form of accounting as it records transactions when dealing with a vendor or customer with cash.
It is the most straightforward accounting method out there and is simple to understand and implement.
However, this method falls short when the business becomes more complex and starts dealing with subscriptions or multi-period contracts.
2. Accrual Accounting
Accrual accounting is a standard accounting method under GAAP (Generally Accepted Accounting Principles), where the transactions are recorded when they are earned or incurred, regardless of their mode of exchange.
This provides more accurate financial reports for SaaS businesses with recurring revenue. It also aligns with standards like ASC 606 or IFRS 15, which a SaaS business needs.
Best SaaS Accounting Software
With an abundance of accounting software for SaaS companies in the market, you need to dig a little deeper to find the best fit for your business.
While looking for the best SaaS accounting software, consider its efficiency in managing workflow and whether it gives you the right support to grow your business.
Here are some of the best options we’ve found out there:
- QuickBooks Online: QuickBooks Online is an excellent option if you’re looking for an affordable and user-friendly solution for your small or medium SaaS business. It maintains recurring billing and invoicing, integrates with payment gateways, and tracks deferred revenue and expenses.
- Xero: If your business needs a little bit more flexibility and seamless integration with other SaaS apps, then Xero is for you. It automates invoicing and payment reminders and customizes reporting, including cash flow and revenue metrics.
- Chargebee: Chargebee’s focused subscription billing and management makes it ideal for fast-growing SaaS businesses. Its compliance with ASC 606 and ability to handle multi-currency taxation must work well for SaaS companies. It also offers real-time subscription metrics like churn, NDR, and MRR.
- NetSuite: While the software mentioned above works well for small to medium businesses, NetSuite is great at handling the complex accounting needs of large companies. It has a comprehensive ERP system, advanced revenue recognition, deferred revenue, and multi-entity management. It also presents customized financial reports for SaaS metrics.
Challenges in Accounting for SaaS Companies
SaaS companies face some uncommon challenges because of their subscription-based revenue model, multi-year contracts, and compliance with strict accounting standards.
These challenges can make financial management and reporting significantly more complex than traditional businesses.
- Revenue Recognition Compliance: A SaaS company must follow strict revenue recognition standards such as ASC 606 and IFRS 15. These standards require revenue to be recognized only when the service is fulfilled. SaaS companies also deal with complex contracts, such as bundled services or tiered pricing, which require precise revenue allocation.
- Deferred Revenue Management: Deferred revenue must be recorded as liabilities until the service is provided. Managing this revenue requires accurate tracking and systematic spread over the subscription period, which can be complicated.
- Expense Recognition and Matching: Failure to match customer acquisition expenses and hosting fees to appropriate revenue periods causes trouble in financial statements and misrepresents profitability.
- Complex Subscription Models: Diverse subscription models, such as tiered plans, usage-based billing, and bundled subscriptions, add complexity to accounting. Additionally, changes such as upgrades and downgrades further complicate revenue tracking.
- Tax Compliance: This is emerging as the new challenge in SaaS company management. Many jurisdictions require SaaS owners to collect and remit various taxes. Determining tax liability across multiple regions, each with its own set of rules can be difficult.
- Multi-Currency Transactions: Revenue and expenses in foreign currencies must be translated into the company’s functional currency, which often requires adjustments for exchange rate fluctuations. This increases the risk of errors and requires an accounting system capable of handling multi-currency reporting.
Best Practices in SaaS Accounting
Taking a strategic approach to managing SaaS accounting requires balancing compliance, efficiency, and alignment with business goals.
We’ve listed some of the best practices that will elevate your strategies and bring accuracy to accounting.
- Collaborate with Revenue Teams: Instead of waiting until the end of the month to examine data, you should collaborate with the revenue team regularly to stay up-to-date with billing cycles, customer contracts, and potential issues. An open communication will make sure that data flows smoothly and consistently, which can avoid last-minute complications.
- Automate Accounting Processes: Accounting teams spend hours on month-end closure reports, which can delay data-driven decision-making. Automate basic accounting tasks through software like QuickBooks or Xero to increase efficiency and eliminate repetitive tasks and human errors. Get real-time accurate data, which aids decision-making.
- Prepare for Scaling: Automate your accounting processes to handle growth in customers, transactions, and complexity. Invest in systems for billing, CRM, and finances to reduce manual efforts.
- Focus on Data Cleanliness for Month-End Closures: Producing accurate reports will be complicated if your accounting data isn’t structured or tagged to support strategic insights.
What Is AccountsBalance?
AccountsBalance is a monthly bookkeeping service specialized for agencies & SAAS companies.
We take monthly bookkeeping off your plate and deliver you your financial statements by the 15th or 20th of each month.
You’ll have your Profit and Loss Statement, Balance Sheet, and Cash Flow Statement ready for analysis each month so you and your business partners can make better business decisions.
Interested in learning more? Schedule a call with our CEO, Nathan Hirsch.
And here’s some free resources:
Frequently Asked Questions (FAQs)
If you still have questions about accounting for your SaaS company, here are some answers.
How Do International Accounting Standards Affect SaaS Companies Operating Globally?
International accounting standards like IFRS promote standardization. This allows investors and stakeholders to compare financial performance across different countries and currencies more easily. This can be beneficial for SaaS companies seeking international investment or planning to expand into new markets.
These standards also have specific guidelines for revenue recognition, impacting how SaaS companies report their revenue and profitability. They also treat deferred revenue from annual or multi-year subscriptions differently.
SaaS companies operating in multiple jurisdictions might need to comply with different accounting standards, complicating reporting and bookkeeping. Meeting compliance requirements might incur additional costs, too.
Are There Any Common Misconceptions About SaaS Accounting Standards That Businesses Should Be Aware Of?
Businesses should be aware of at least these two common misconceptions to avoid encountering roadblocks or making misinformed decisions. First, even free trials can have accounting consequences. Consult with your accountant to determine the appropriate treatment for free trials based on your specific offering. Second, while basic bookkeeping software might work for simple businesses, SaaS accounting often requires specialized features. These might include subscription management tools, multi-currency capabilities, and integrations with revenue recognition automation tools.
What Are the Key Financial Metrics SaaS Businesses Should Track?
Tracking the right financial metrics is essential to understand performance and make data-driven decisions. Key metrics include:
- Monthly Recurring Revenue (MRR)
- Annual Recurring Revenue (ARR)
- Customer Acquisition Cost (CAC)
- Customer Lifetime Value (CLTV)
- Churn Rate
- Net Revenue Retention (NRR)
- Burn Rate
These metrics give an idea of growth, customer retention, and financial health.
What Are the Tax Benefits Available to SaaS Companies?
Just like any other company, SaaS companies also get various tax incentives and benefits. It’s provided to encourage growth, innovation, and investment in technology and research.
- Research and Development (R&D) Tax Credit: SaaS companies can claim R&D tax credit for developing or improving software, which includes programming, testing, and overcoming technical challenges.
- Deduction for Software Development Costs (Section 174): Under the Section 174 of the IRS code, SaaS companies can deduct software development expenses, including labor and materials.
- Qualified Small Business Stock (QSBS) Exemption: If a SaaS business qualifies as a Qualified Small Business, founders and investors may be eligible for a tax-free capital gains exemption on stock held for more than five years, subject to certain conditions.
- Accelerated Depreciation (Section 179): SaaS companies can use Section 179 to immediately deduct the cost of purchasing software or equipment instead of depreciating it over several years.
- Tax Deductibility of Marketing and Acquisition Costs: Customer acquisition and marketing expenses—such as advertising, lead generation, and SEO—are deductible as ordinary business expenses, reducing taxable income.
Conclusion
SaaS companies follow the same general accounting standards as other businesses. Specific guidelines do apply to recognizing revenue over the subscription period, though. Understanding how GAAP or IFRS applies to the unique aspects SaaS businesses is essential for accurate financial reporting.
Remember that ASC 606 applies to US companies and IFRS 15 is the international standard. The specific details of these standards can be quite complex. If your business offers SaaS services, we recommend consulting with a qualified accountant to ensure proper implementation.
