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What Accounting Method Should My SaaS Company Use?

February 20, 2015

While the business model of receiving payment in advance for something that is delivered over time in the future is not new by any means (magazines), and nor is the ‘generally accepted’ manner in which to financially account for these subscriptions, the software industry, particularly smaller, private companies, continue to differ on what method of accounting is most effective to manage their individual business.

The Subscription Income Statement

Zuora, in particular, has promoted the use of the ‘Subscription Income Statement’ as the preferred method for analyzing the performance of a subscription software company.

The metrics and analysis in ‘Subscription Finance’ are critical to determining the right amount of sales and marketing spend, how much to discount, and, ultimately, how much your company is worth.

That said, the subscription income statement is more of a subscription software-specific version of the managerial accounting contribution margin income statement. It’s useful for exactly the points above – to analyze past performance to help answer strategic and tactical business questions for the future.

Cash Accounting

For smaller, earlier-stage companies, cash accounting is great. This simple method is useful because it ‘just makes sense’. Meaning revenue and expenses are simply cash in and out that period, and for small companies, entrepreneurs’ minds are on the cash and the balance in the bank and their financial statements align with that financial strategy.

But as companies grow, complexity increases, initially manifesting itself as an adjustment here, or there, but eventually snowballing into a host of ‘adjustments’ that end in ‘Cash Basis’ accounting statements with consistent accounts receivable and accounts payable balances.  Cash accounting becomes less appealing as the company grows and introduces multiple pricing and payment tiers, discounts, trade terms, and introduces new financing and tax complexities.

Accrual Accounting

As Winston Churchill said, “Accrual accounting is the worst form of accounting except for all those other forms that have been tried from time to time.” Ok, I might be misquoting him slightly, but the point remains. Double entry, accrual accounting is a weird beast. And what’s up with abbreviating debit ‘dr’?

But accrual accounting exists for a reason, and, despite what some would say, is the most appropriate method for SaaS companies.

Accrual accounting aligns revenue earned in a given period with the expenses incurred (amount and timing) in generating that income. This method also ‘just makes sense’.  In fact, it makes more sense than cash accounting, especially for SaaS businesses. Accrual revenue, if recognized correctly, actually tracks along with MRR. So with accrual accounting it’s actually easier to tie back a managerial performance and growth view, such as the subscription income statement, than is cash accounting. Another important benefit of accrual accounting is that, by its nature of spreading multi-period events across time, it smoothes the accounts into easily trackable and comparable trends. Cash accounting features too much month-to-month noise to see any real trends.

The purpose of accounting statements is to provide accurate, consistent and comparable information to a broad range of stakeholders, including management, investors, customers, banks and governments. Accrual accounting does exactly this, especially for subscription software companies where monthly recurring revenue and growth are critical metrics.

Rob Belcher

Managing Director, SaaS Capital

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