Software as a service (SaaS) is the fastest-growing software sales model, but accounting complexity can pose challenges. Many of the challenges arise from how SaaS providers deliver their services: The intricacies of subscriptions can make it difficult to parse precisely how to apply accounting rules, sales taxes, contract renewals, commissions and other variables.
Finance teams need to unravel the particulars of SaaS accounting to ensure they're properly reporting and forecasting — not to mention staying compliant with Financial Accounting Standards Board (FASB) and International Financial Reporting Standards (IFRS) rules and relevant tax laws.
What Is SaaS Accounting?
Industry growth has coincided with significant SaaS accounting changes. Among the most recent — and impactful — are ASC 606 and IFRS 15.
FASB's ASC 606: Revenue from Contracts with Customers replaces the rules in ASC 605: Revenue Recognition, while IFRS also amended its guidance to match FASB rules more closely (but not exactly) with IFRS 15: Revenue from Contracts with Customers. In both cases, the rules state that a significant percentage of a SaaS company's revenue and expenses must be recognized over the service subscription life rather than when they are received or incurred.
That has created a globally standardized — albeit complex — set of rules for SaaS accounting that apply to companies if they meet certain criteria, namely:
- The company retains sole possession of the software, and customers have no contractual right to take possession of the software, unlike when licensing or purchasing software.
- Customers may not run the software on their own or a third-party's hardware.
- The company's employees administer the SaaS services, and delivery of performance obligations cannot occur by the customer or a third party.
Most SaaS providers fulfill all three criteria, making specialized accounting rules widely applicable to this market.
Common SaaS Accounting Challenges
Even with the robust framework that FASB and IFRS rules provide for recognizing revenues and expenses, SaaS providers face additional accounting hurdles. These challenges can cause significant financial reporting issues; risk noncompliance with state, federal and international tax and other rules and regulations; and determine figures such as customer lifetime value (CLV), a complex task for finance teams.
Let's look at three specific SaaS accounting challenge areas.
Knowing when to recognize revenue
The most common — and significant — challenge for SaaS companies is knowing when to recognize revenue. Because the customer never "obtains control" of the good or service, the general rules of revenue recognition don't apply. Instead, FASB rules require SaaS companies to recognize much of their revenue over the contract term in most cases. That is true whether the SaaS provider receives the entire balance for the service upfront or utilizes a weekly, monthly, quarterly or annual subscription model.
Knowing how to manage expenses
SaaS providers must also spread many of their expenses across the contract term or estimated customer relationship lifetime. Knowing which expenses businesses must amortize and which may be recognized immediately is essential. Like revenues, the SaaS business must recognize certain expenses at certain times.
Collecting sales tax
Managing sales tax is another significant challenge for SaaS providers, which often have remote workforces and operations and sales that encompass multiple states. While SaaS companies are not always required to collect sales taxes on their services, some states do tax software in some or all services categories. SaaS companies are accountable for the sales tax rules in the states in which they have nexus.
How to Handle SaaS Taxes
SaaS providers require some specialized accounting know-how to avoid costly mistakes. Taxation is one of the most complex areas and carries the potential for significant penalties.
SaaS Companies and Sales Tax
A lack of physical software and SaaS companies' web-based nature makes knowing when to collect sales tax a complicated issue. Some states, such as Arizona and New York, treat SaaS the same as any software sold in-store or purchased and downloaded, and sales tax is applied accordingly. Other states, including California and New Jersey, view SaaS solely as a service that is not taxable. Even more confusing, some states do not require SaaS companies to collect sales taxes, but cities within them do, such as Illinois and the city of Chicago.
Complicating things further, SaaS companies operating over multiple states must follow nexus rules to determine if they need to collect sales taxes. While the basic definition of "nexus" means having a "substantial physical presence" in a state, internet-based commerce has driven changes to how this concept is interpreted.
Some states have enacted "affiliate nexus" laws that stipulate that out-of-state businesses establishing a physical connection through in-state employees, contractors, affiliates or other representatives must collect sales taxes in those states. Others have introduced "economic nexus" rules requiring out-of-state companies to collect sales taxes after reaching a certain sales revenue threshold or transaction volume in that state.
SaaS companies have many of the same expenses as any business, plus some expenses unique to software providers and cloud-based organizations. These generally fall into four expense categories:
General & administrative. G&A expenses comprise the day-to-day operating costs of running a business that doesn't relate to producing a good or service. While not related to the production of a SaaS provider's product or service, SG&A expenditures are still necessary to keep the business going. Common SG&A expenses include office space, utilities, clerical supplies and payroll.
Sales and marketing. Sales and marketing expenses are the "S" part of the commonly used SG&A KPI and are related to a SaaS provider's efforts to publicize and promote its services. Sales and marketing expenses include print, TV, digital advertising costs, sales and marketing collateral, customer-facing website expenses, marketing automation tools and public-relations costs.
Similar to R&D staffing, these expenses should include payroll for sales and marketing staff, including commissions.
Research and development (R&D). R&D expenses can be a large part of a SaaS provider's budget, especially in the early stages. These outlays encompass the cost of equipment, licensing software and any other expenses incurred from developing the software and services.
Although most payroll is considered an SG&A expense, the staffing costs for developing the software and services a SaaS provider sells, such as the engineering team's salaries, are part of R&D.
Cost of goods sold (COGS). Cost of goods sold (COGS) is strictly for direct expenses required to deliver the SaaS application. Among the most common costs that comprise the COGS for a SaaS business are hosting and server expenses and transaction fees. SaaS providers may also use a related metric, cost of revenue, including all the COGS components and direct costs for the sales function, such as commissions, sales discounts, distribution and marketing. Like COGS, cost of revenue excludes indirect G&A costs, such as manager salaries, that do not attribute to a sale.
SaaS companies can recognize some of the above expenses immediately, while they must defer others.
Incurring and Deferring Expenses and Revenue
Financial reporting rules require SaaS companies to spread many of their expenses over the contract term or the estimated customer relationship lifespan, whichever is longer. There are specific rules regarding which expenses SaaS providers can defer and how they should handle specific expenses, such as sales commissions.
Expenses, commissions and revenue
Most SaaS providers utilize the accrual accounting method, meaning that they record revenue when a purchase transaction is earned, not when the money is received.
The key here is to defer these expenses and recognize them in portions equal to the revenue item to which they are attached. For example, a $1,200 commission for a 12-month customer contract would see the commission divided into 12 equal amounts of $100, with $100 removed from the liabilities section balance sheet and added to assets, shown on the income statement when recognized.
Revenue Recognition for SaaS Companies
The revenue recognition principle, under accrual accounting, requires that revenues are recognized on the income statement in the period when realized and earned — not necessarily when cash is received. Earned revenue accounts for goods or services that have been provided or performed, respectively. Most SaaS providers use the accrual accounting method, meaning that they record revenue when the sale is made, not on a cash basis which records revenue when the money is received.
ASC 606 and IFRS15 establish when businesses should recognize the revenue for contracted services. This generally happens when a company transfers control of the service to the customer. However, because SaaS customers never obtain control of the service, the "transfer" happens in increments over the contract's life. That means that under ASC 606 and IFRS 15, SaaS providers must recognize the revenue from services sold in increments over the contract's life with the customer.
5 Steps to SaaS Accounting Revenue Recognition
ASC 606 provides a five-step framework for recognizing revenue. These guidelines delineate the appropriate revenue recognition measures and eliminate inconsistencies and ambiguity in SaaS accounting practices.
Identify the contract with a customer: Companies follow this step when they sign new customers up for the service.
Identify the contract's performance obligations: For this step, the provider must make sure the contract explicitly states the services they're providing, how long those services are for (the contract term) and the obligations and rights of the customer and the SaaS provider. This includes listing the service deliverables as well as obligations.
Determine the transaction price: This is the amount the provider expects to receive for providing the contracted services. That figure encompasses the total of all standalone and bundled services as well as any discounts.
Allocate the transaction price: This step requires the allocation calculations from the previous section. Because most SaaS companies work on an ongoing subscription basis, the allocation timeframe for lengthier contracts, say 12 months or more, can be broken down for recognition purposes. That calculation is often 30 days, as it's the smallest billing cycle for most SaaS providers.
Recognizing revenues upon satisfying the performance obligation: In this final step, SaaS companies recognize revenue as they meet performance obligations and the customer benefits from the service or services provided.
SaaS providers must have an established contract with the customer, clearly defined services, rights and obligations, and proper pricing and allocation before recognizing the revenue from their services.
Overcome SaaS Accounting Challenges With Accounting Software
The nature of SaaS accounting requires a significant amount of knowledge and insight. Unfortunately, many SaaS providers still rely on disconnected systems and spreadsheets and other manual processes. That often leads to disorganization, oversights and costly errors.
So, what are best-in-class SaaS companies doing to combat these issues? They're utilizing modern financial management and accounting software that offers fully integrated, comprehensive functionality across accounting and financials. That enables SaaS businesses to streamline and optimize their financial management efforts by automating manual tasks such as sales tax calculations.
The right software can also provide meticulous financial reporting that enables SaaS providers to comply with state, federal and international accounting standards and successfully navigate audits and other financial examinations.
Having a solid understanding of SaaS companies' accounting rules is paramount, but the rules and regulations governing SaaS accounting can be overwhelming. That's why working with a knowledgeable partner is essential.
NetSuite's revenue recognition functionality allows SaaS companies to segment services and automatically defer revenue under predefined rules. The system creates, updates and posts all recurring revenue records automatically. That automation eliminates manual entry errors and assures compliance with accounting standards such as ASC 606 and IFRS 15.