One of the challenges Software-as-a-Service (SaaS) companies often encounter is figuring out how much money they’ve made. That sounds implausible, but the nature of SaaS billing and reporting is more complex than it seems at first glance.
Take this relatively basic example. Your business offers one plan type for $12 per month. Alternatively, users can buy a full year of access for $120. On top of the monthly fee, there’s a $20 setup cost. Customers can quit at any time, but there’s a $25 early cancellation fee.
In the grand scheme of things, not overly complex. Here’s the question—if a new customer buys a full year of access in January, how much money will you have made?
Why accrual accounting is important
Let’s take a step back.
In the world of retail, cash is king. Really, it’s king everywhere, but hear me out.
Classic retail situations involve straightforward transactions. You enter my store and give me $10 in cash for a copy of “Days of Thunder”, and I give you the DVD.
Cash basis accounting
On the books, I immediately recognize the $10 as revenue. That’s the idea behind cash basis accounting. Cash accounting recognizes revenue as soon as you have the cash in your hand.
This makes all kinds of sense for retailers, restaurants, or anyone who provides a product or service immediately upon receiving a payment. Person rakes a yard, gets paid, and recognizes the revenue. Individual sells a pizza, gets paid, and recognizes the revenue.
In all these cases, there’s nothing left on the table. For most purchases, cash accounting is simple and intuitive.
Accrual basis accounting
But, what happens when you pay someone to come paint your house? Often, you have to pay a portion of the cost upfront. The painting company now has half of its revenue in hand before it’s done any of the work.
What happens if the painting company goes out of business? It owes money to everyone who has paid for work that hasn’t been completed. How can we track what’s been paid for against what’s been provided? Enter accrual accounting.
Accrual accounting smooths out the what ifs by matching revenue to products or services provided. In accrual accounting, you only recognize revenue once you’ve provided the service or product that was paid for.
In the example above, the painting business would take in half of the revenue right away, but only record that revenue once the job was half completed. When it gets the final payment at the end of the job, it can recognize the rest of the revenue immediately.
Most accounting software allows you to use either method, but check before you buy.
Why SaaS businesses need accrual accounting
In the SaaS model, you’ve got tens, hundreds, or thousands of customers who have paid for a service or product you’ve yet to deliver. Everyone and their cousin offers a discount when services are paid yearly, which means you’re often sitting on a pile of cash received for tasks you haven’t yet completed.
When we’re talking about one job—painting the house—it’s pretty easy to sort out what you’ve made and what work you need to do. With all the moving parts of a SaaS business, this becomes a more difficult task.
A basic deferred revenue example from a business that bills on a calendar year cycle.
On top of the headache of trying to track these moving parts, you also need a system that reflects the actual work your business is completing over the course of the year.
Imagine if all your subscribers sign up for a full year in January. Are you going to recognize $15 billion in January and then nothing else throughout the year? What if a bunch of people cancel in July? Do you record a full month of income, and then one full month of losses?
Such recording systems won’t represent the services you’re providing. You won’t be able to match server fees or overtime costs to the months in which you actually made money. If you frontload your revenue, nothing else will make sense.
To track payments against services provided, SaaS businesses use deferred revenue.
When a SaaS business collects money before providing a service, it needs to both hold onto that cash and recognize it as the service is provided. To do that, it defers recognition of revenue until it has fulfilled associated customer obligations.
This means that deferred revenue ends up as a line item on your balance sheet. It’s a liability, because it represents something you owe someone else. A customer gives you cash in exchange for a service. Until you provide the service—this is the accrual accounting bit—you can’t recognize the revenue.
Twists and turns in SaaS accounting
There are all sorts of caveats and counterintuitive components of deferred revenue. Let’s go back to our original example. We now know that, in the first month, we’re only recognizing 1/12th of the yearly fee. On top of that, we can recognize the $20 setup fee, since that service is provided immediately.
What about the $25 cancellation fee? What if there was no option to cancel, and you just had to pay off your year? Even in these cases, no additional revenue is recorded until those liabilities are cleared.
You might think, “If they can’t cancel, then this $120 is guaranteed, so I can recognize the whole thing.” However, you still owe the customer a service for the money they’ve given you, which means the balance can’t move from your liabilities to your revenue until you either provide the service or they cancel their subscription.
If they sign up in January and cancel in February, you can recognize the $25 fee. At that point, there’s nothing owed to the customer. Here’s a chart of what these scenarios look like:
Deferred revenue when cancellations occur.
Using deferred revenue to plan and profit
Any SaaS business can—and absolutely should—implement deferred revenue as part of its accounting program. Not only does it make life simpler, it also makes it easier for the business to plan.
That’s because deferred revenue allows you to better understand your business’s real monthly income and monthly recurring revenue (a measure of monthly revenue that takes deferred revenue as its starting point).
From there, you factor in growth, churn, and upgrades to figure out how much money you’re going to have in five months. With that information, you can make better decisions about your investments along the way.
Your recurring revenue will change, by the way. This isn’t a number you predict in January and run with for the entire year. It’s a forecast that should be constantly updated based on the actual patterns that emerge in your business.
Deferred revenue is the start of the process, but the process itself is ongoing.
How do you forecast and plan?
What other accounting tips and tricks does your business rely on? While deferred revenue is a big one for the SaaS community, it’s not the only horse in the stable. Share your preferred system in the comments below.
Also, drop me a line if there’s a topic you’d like us to cover in a future post. I’m always interested to hear what readers have to say.
For more small business and startup tips, check out other pieces on Capterra’s Knocking Down Doors blog.
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