Accounting for SaaS Companies: Why Go GAAP Early in SaaS?
Accounting for SaaS Companies: Why Go GAAP Early in SaaS?
In most emerging and growth SaaS businesses, the focus is on cash flow and growth. The bookkeeping — and choice of accounting method — is many times left to whoever is sending the invoices and paying the bills.
And the method tends to be whichever is most accessible and least expensive.
Since you have to file taxes (and for most early-stage companies, taxes are done on a cash basis), the company books tend to remain that way. However, what you save in bookkeeping costs now may really cost you later.
Accounting for SaaS Companies
When it comes to taxes, there are a number of IRS rules that determine if you have the option to use either, or if you are required to use a specific one.
However, for GAAP financial statements, the accrual method is the only approach. That means you accrue revenues for subscriptions and other services that are delivered over time, and you do the same for expenses such as rent, sales commissions, and service expenses delivered over time.
Naturally, if you raise capital and your investors require an audit, you are going to be concerned with proper GAAP financial reporting. Most small and emerging businesses don’t, and therefore don’t typically concern themselves with GAAP financials. It is sometimes difficult to justify the overhead and expense of keeping your books using the accrual method, especially if you keep tax books using a cash method.
But when it comes to accounting for SaaS companies, there really is a need. It’s called liquidity! It might be far off into the future, but it’s out there. Whether it’s through a merger, acquisition, or if you’re one of the lucky ones to go public, the need is great.
For most traditional businesses, liquidity comes through cash flow. For many others, including most SaaSbusinesses, liquidity comes through an acquisition. It’s the acquisition that drives the need to switch to accrual accounting.
Cash Accounting vs. Accrual Accounting
The cash accounting method is straightforward. It simply means that revenue is recognized at the time that money changes hands. For example, you own a sandwich shop, and someone orders a sub from you. You whip up the sub, they hand over their $10, and you recognize the revenue from that transaction right away.
The accrual method, on the other hand, is often used in service or subscription businesses where the product/service is being delivered over a period of time. For example, Spotify charges you $15 a month for Spotify Premium.
Even if you were to pay for the year upfront, Spotify would not recognize all of the revenue for that transaction until the end of the year when the service had been completely rendered.
Under the accrual method, Spotify would instead recognize the revenue incrementally over the period that the service is rendered. For B2B companies with term subscriptions, this gets infinitely more complicated.
Things like mid-month start dates for contracts and service & onboarding fees make the accrual method complicated for B2B SaaS, but it is a more accurate reflection of a company’s cash position, hence why the FASB requires it for GAAP compliance.
Accounting For SaaS Companies Considerations
The company looking to acquire you produces GAAP financials.
The huge fish eat the big fish, and the big fish eat the small fish. You are the small fish. The huge fish is likely a public company and works exclusively with GAAP/accrual accounting. No surprise there. What might catch an entrepreneur off guard is the fact that the big fish is almost certainly using the accrual method for taxes and producing GAAP financial statements.
A corporation with revenues in excess of $5 million is typically required to report taxes using the accrual method, and since the big fish has investors and a Board, and is looking to get taken out by a larger fish, he produces GAAP financials.
Remember, the big fish almost always creates liquidity through the same method as small fish: acquisition. It runs downstream, so to speak.
3 things to prepare for before acquisition conversations:
When you enter into acquisition discussions, you will need audit-ready, GAAP-compliant financial statements. No big deal, right? Here is the catch: It’s significantly harder to generate financial statements when your record-keeping and culture are based on “cash” accounting. The impact is significant.
- The cost of the audit and accounting efforts climbs dramatically.
- It takes significantly more time. Time almost always works against you during due diligence and closing.
- Most importantly, there is the buyer perception of significantly added risk — risk to the buyer that your financial statements may not be accurate (anything done after the fact is always going to be perceived as riskier).
The more history to recreate, the riskier the purchase. How do buyers manage risk? Through lower valuations, bigger hold-backs, and more earn-out. These transaction adjustments are often thrown in during the final days and in minutes of the closing.
Start Preparing For an Audit Now
If an acquisition is a possibility for your business, save yourself some heartache and preserve your valuation. Start now by adopting proper revenue recognition and expense amortization practices that are essential to accrual accounting.
Remember that selecting the Cash or Accrual options in QuickBooks isn’t the answer. That only changes the income reporting period from the payment date to the actual invoice date.
You will need to manage revenue recognition and expense amortization in a spreadsheet or product like SaaSOptics because QuickBooks has no inherent ability to do so.
With SaaSOptics, we can help you manage the ins and outs of your revenue recognition, plus billing and invoices, customers and renewals, metrics and analytics, and so much more. If you’re interested in learning more about how the SaaSOptics platform can help you better manage your business, reach out for a free demo of our platform.
You can also check out our resource, 11 Things to Do Now to Prepare for Your First Audit, to learn what you need to do to prepare for your first audit.