According to Gartner, the SaaS industry is projected to grow to a staggering $121B in 2021, a 15% increase from 2020.
And this trend will continue. Based on a 2019 survey, Gartner forecasts that eighty-four percent of new software will be delivered as SaaS, and this percentage is expected to increase as existing providers transition to a subscription-based model. Yet, many software providers are ill-prepared for the unique challenges and opportunities that come with managing customer subscriptions and transitioning to a SaaS model.
So, what is SaaS accounting, and how will it affect your business? Let’s start with the concerns.
One challenge is how software providers manage their order to cash process and capture, share, and use financial metrics internally. When transitioning to a SaaS model or developing a SaaS business, many companies utilize spreadsheets, disconnected systems, and other manual processes to manage their recurring revenue business. These companies also tend to take the same methods and principles used to maintain a traditional software business and implement them in the SaaS business. The result? A mess of calculations that don’t accurately give insight into the state of the company.
If you aren’t already working with a SaaS business in some capacity, the chances are high that you will soon. As an accounting professional, it is crucial to understand the differences in managing the operations and finances of a traditional software business versus those of a SaaS business.
Cash Accounting vs. Accrual Accounting
The main difference between accounting for a subscription vs. a traditional business is the method used. In a traditional business, the cash accounting method is used. This means that revenue is recognized at the time of the transaction. For example, when you go to Macy’s to buy a shirt, Macy’s recognizes the revenue from that shirt sale as soon as you fork over your credit card.
In subscription business on the other hand, revenue cannot be recognized all up-front. It must be recognized over the duration of the subscription. This is due to what’s known as performance obligations. If you sign a one-year agreement with a streaming service for example, you could potentially pay for the year up-front to obtain some kind of discount, but that provider cannot recognize all of the revenue from that sale until the services have been completely rendered. This is what’s known as accrual accounting.
The Problem with Spreadsheets for SaaS Accounting
Spreadsheets are old news. Embedded in the foundation of traditional accounting and bookkeeping, they are unable to function effectively in the dynamic and constantly shifting nature of a SaaS business.
For starters, subscription terms can vary and come in multiple forms, and end-user agreements can change daily. With that kind of volatility, a business can quickly end up managing multiple, disconnected spreadsheets. Plus, periodic financial reporting becomes inefficient, taking far longer than it should. The spreadsheet process is also highly susceptible to errors, and it’s nearly impossible to generate accurate operational and financial reporting data efficiently.
The worst part? With spreadsheets, real-time, accurate financial metrics are difficult to produce, and as the metrics are often inconsistently defined, there is a high risk that the data is unreliable. This can have a profound effect on the ability of a business to use financial and accounting data to make informed decisions. Also, during an audit, the inability to produce reliable operational and financial data makes the process extremely cumbersome and painful for your team, your board members, and yourself.
In the early stages, many SaaS businesses supplement spreadsheets with general ledger software as an “easy option,” but quickly realize that general ledger software doesn’t efficiently manage subscription revenue recognition or subscription billing, especially if the contracts include sales-negotiated behavior, which is required by ASC 606 Revenue from Contracts with Customers.
The Difference in Revenue Recognition
There’s a reason revenue recognition gets complicated with SaaS businesses; it’s incredibly easy to mistake cash for revenue.
In accordance with the U.S. Generally Accepted Accounting Principles (GAAP), an entity cannot fully recognize revenue from a contract until the agreed-upon services have been delivered. With varying contract lengths, bundled services, and add-on services, SaaS businesses require the ability and the flexibility to recognize revenue in a manner consistent with their agreements (and following GAAP).
In B2B SaaS, this may include a combination of amortizing revenue over the term and recognizing revenue upon the completion of certain contractual milestones. This is further complicated by the inherent customer contract volatility in SaaS businesses. Software upgrades, downgrades, renewals, re-negotiations of renewals, upgrade-extensions, cancellations, and early terminations are all fair game in B2B SaaS, and they all put pressure on the financial teams as general ledger software and spreadsheets are poorly suited for revenue accounting due to the extensive contract variations among customers.
Revenue recognition is easy to understand but can become extremely complicated in practice — especially for a SaaS company. Accounting standards boards and regulatory agencies have established complex guidelines to reign in aggressive revenue recognition actions that inflate actual performance. Thus, it is critically important to ensure recurring software revenue is recognized consistently and adheres to ASC 606.
Learn more about SaaS revenue recognition in the video below:
GAAP Financials and Accurate Metrics
For SaaS companies, accurate GAAP financials and metrics are vital, since SaaS models primarily rely on future revenue and performance. For example, it’s always imperative to know if the lifetime value is higher than customer acquisition costs if the company is offsetting churn with expansions, and more — and relying on spreadsheets to report those numbers accurately is very problematic.
GAAP financials indicate where the business stands today but reveal very little about the composition (new vs. existing) and reliability (high vs. low churn) of recurring revenue. Subscription businesses to track SaaS-specific metrics such as monthly recurring revenue, annual recurring revenue, average contract value, customer lifetime value, churn, and customer acquisition costs to accurately report on what’s working well and what needs to be improved.
So How Do You Fix Accounting & Financial Operations for SaaS Companies? Automation is Key.
The key to successfully managing the finances of a subscription-based business is automation. SaaS-specific automation technology is essential for using benchmarks and metrics to gain visibility into the company’s performance—and it’s also critical for assessing your company’s health automatically.
Subscription management solutions can eliminate the need to re-key information or manually enter data by automatically turning closed opportunities into GAAP-compliant customer, contract, subscription, revenue, and invoice schedules—information that can also flow automatically into the general ledger system. They will also provide the polished, accurate revenue recognition, and financial metrics that will inform operational decisions, streamline audits, and satisfy potential investors or buyers.
At SaaSOptics, we’ve got the opportunity to help you solve the problems that are most painful for the growth of your business—and help you shape the future with the features and functions you need to grow and scale. If you’re interested in learning what a subscription management solution could look like for you, let us know. We’d be happy to show you what it looks like live with a free demo of our industry-leading platform.