Why accrual accounting is necessary for SaaS and Subscriptions
Unfortunately, bookkeeping isn’t as simple as recording when money comes and goes from your bank account. To have an accurate sense of the financial health of a business, the accounting practices have to be a bit more nuanced than that.
This is particularly true for Software-as-a-Service and subscription business models, whose revenue is comprised mostly of routine charges, but also mixed with one-off fees and upfront payments.
SaaS and subscription businesses obsess over Monthly Recurring Revenue (MRR) to ensure their own growth. Can you guess what lays the groundwork for this almighty SaaS metric?
Revenue recognition, which you can learn how to implement in your business.
And accrual accounting, which you can learn about right here, right now!
Let’s start with some basic definitions.
What is accrual accounting?
A quick tutorial of what accrual accounting is, exactly, and the concepts it involves.
Let’s first hear from the authority on most financial matters, at least in the United States, the Internal Revenue Service (IRS):
“Under the accrual method, you generally report income in the tax year you earn it, regardless of when payment is received. You deduct expenses in the tax year you incur them, regardless of when payment is made.”
The very term "accrual" refers to any individual bookkeeping entry, where you record revenue or expense in the absence of a cash payment.
So, the general idea in accrual-based accounting is that you mark your books when agreements are made, services are provided, and items are ordered. It doesn’t matter when the money actually changes hands. You mark your books based on transactions and obligations, not payments.
It’s important to differentiate between transaction and payment. A payment is a one-way movement of money, from consumer to provider. A transaction is a two-way exchange, whereby the provider provides the value that the consumer pays for. In the transaction, the provider actually earns the payment, by delivering on their side of the deal.
Following this method, revenues and expenses are tied together, in the same report, in the same month they occurred. This is called the matching principle. And it deserves an example.
It’s August. You earned $100 revenue by providing your SaaS, but you were paid for it in July. You got a $100 bill for office utilities, but you won’t pay it until September. Both these amounts are attributed to the month of August, matched in the proper month where they’re incurred, rather than to July and September.
By reporting both at the same time, i.e. matching them, you have a clearer view of how your business operated in the month of August. What money did you spend, and what money did you earn? How are they related? Based on bank transfers alone, you wouldn’t have that clarity.
With accrual-based accounting, you often recognize revenue after the money is already in your account. And you recognize expenses before the money has left it.
Subscription business models are the perfect example of a revenue structure that requires the accrual method. Payments are made upfront, service is meted out over time. You recognize revenue as you provide the service. Accrual accounting reflects all of this accurately.
If you need a quick refresher, check out the difference between accounting and bookkeeping!
When accrual accounting is necessary
Not only is the accrual method recommended for SaaS and subscription businesses, it’s often required! Here are the following circumstances where you better have accrual accounting underway:
- Your annual sales exceed $5 million and your venture is structured as a corporation.
- You have inventory of any kind. Do you produce, purchase or sell merchandise? Got stock on the shelves? Use the accrual method for all sales and purchases.
The benefits of accrual accounting
Clearer cash flow, better decisions
Should you upgrade your technology stack, make that new UX hire, or move to a bigger office? All of these decisions involve investing money back into your business. And you can’t make any smart decisions without understanding exactly how much money you have to reinvest.
When you have a subscription business model, cash flow can be confusing. A glance at your bank account tells you nothing about how much money is actually at your disposal. You may have more, you may have less.
If you look at your accrual accounting books, all assets and liabilities are already reported. You have a clear view of your current resources and can plan more strategically.
Comply with international accounting standards
Save yourself the heartache and comply with accounting standards from the get-go. Accrual accounting is one of the Generally Accepted Accounting Principles (GAAP) in the US, and International Financial Reporting Standards (IFRS) around the world.
Track your MRR with accuracy
As mentioned above, accrual accounting mirrors the most important SaaS metric, Monthly Recurring Revenue (MRR). For a deeper understanding, learn more about MRR and other vital SaaS metrics.
Identify business trends, not just bank transfers
Accrual accounting ties together revenue and the expenses spent in generating that revenue, so you can identify overall business trends. Which efforts and investments lead to better performance? You can tie revenue performance with internal processes and marketing tactics, which helps you understand your growth.
How does accrual accounting differ from cash-based accounting?
Cash-based accounting is the simple, easy-going cousin to accrual-based accounting. It’s the method most businesses start with, because it’s so straightforward. But as your business grows and your revenue becomes more complex, you’ll need to transition to accrual-based anyway. Here’s how cash-based accounting works.
Essentially cash-based accounting is based on the bank transfers. Revenue and expenses are recorded when received and paid, rather than when earned and incurred.
The two different methods have dramatically different effects on your cash flow calculation.
For example, let’s say the following transactions took place this month:
- You sent 20 bills to customers, $100 each for their monthly subscription = $2,000.
- You received an invoice for $500 from a UX contractor, who just completed a project.
- You paid last month’s utility bill, at $75.
- You received $600 from a new customer, paying upfront for six months.
Using the accrual method, your profit for the month would be $1,500 ($2,000 in monthly subscription income minus the $500 UX bill).
Using the cash method, your profit for the month would be $525 ($600 in upfront payment income minus $75 in utilities).
Sometimes there’s a tax benefit to the cash method, especially for new businesses. You record December expenses right away but can delay recording income until the next tax year, when you’re paid in January. Ergo, you pay less tax for that year and have more money to work with as you keep growing.
But generally, the cash method is only appropriate for a small, cash-based business, not SaaS or subscription models.
How to implement accrual-based accounting
The day you make a sale, mark it to “accounts receivable.” This means you’re expecting the revenue, but haven’t earned it yet. It’s an ensured pipeline in. Accounts receivable is listed in the “current assets” section of your balance sheet.
Consider the revenue earned as you fulfill the service obligations to your customers. For in-depth guidance on this step, read how to implement revenue recognition in your business.
Mark them the day you receive the services, not when you pay the bill. You mark expenses to “accounts payable.” This means you’re expecting to pay the money, but you haven’t yet. It’s an ensured pipeline out. Accounts payable is listed in the “current liabilities” section of your balance sheet.
But hey! We’re in the 21st century here. You don’t have to do this all manually or all on your own. Some cloud-based software could help you manage accrual-based accounting automatically. For further guidance, please check out our guide on how to choose the right accounting tool for your business.