It is vital for every business in the SaaS space to keep track and account for the business’s financial transactions. You need to keep a record of every revenue and expense generated and incurred by your SaaS business to keep up with cash flow and measure your business growth. The question, however, remains, “what accounting method is the most suitable for my SaaS business?”.
Choosing the right accounting method is as critical as it is a major determining factor of your company’s growth measure. The right accounting method can save your business a lot of money and optimize your capital. This article will take you through the two major accounting methods SaaS companies use and suggest the best option for your business.
SaaS accounting gives you a broad overview of how your SaaS business maintains and manages cash flows and gives you an insight into how to make accurate financial decisions. The two accounting methods used by SaaS companies are accrual and cash accounting.
These accounting methods differ based on the timing at which they record the transactions that take place within the company. However, each accounting method still benefits businesses, depending on what the business wants at the moment.
Below, we will discuss the advantages and disadvantages of cash vs. accrual accounting to help you discover what’s best for your SaaS business.
Cash accounting is an accounting-based system that records financial transactions, both revenue and expenses, only when cash is exchanged (either received for revenue or paid for expenses). This means that the only time a transaction can be confirmed in the accounting system is when the business receives or spends cash.
Your SaaS business might have offered services to a client since February, but the client just paid in May. Any input into the cash accounting system would be dated to May since that was when cash was exchanged. The same thing goes for business expenses too.
A cash accounting system is an excellent option for small SaaS businesses or cash-based businesses as it keeps them updated about their cash flows, both inflow, and outflow.
Cash Accounting Advantages
Simple to maintain:
Cash accounting is one of the simplest account methods to maintain. There are no complexities involved. You have to keep track of when money enters or leaves the business. There is no need for any advanced skills to take down the records.
Its simplicity is why Forbes Finance highly recommends it for small businesses that are just starting.
Gives an insight into cash flow:
Cash accounting is the easiest method that gives insight into how money is made in the company. It shows an account of where the company’s money is going and where money is coming from, without any stress.
Cash Accounting Disadvantages
Inability to track MRR:
You cannot calculate your company’s MRR, or monthly recurring revenue, with the cash accounting system. Its records do align with when the money came in, but not how the money came to be, and not being able to discern what month the services were rendered or the expenses were incurred.
Inability to determine business performance:
Although the cash accounting method can measure your cash flow, you cannot determine your business performance with its records. It doesn’t consider how much growth you’ve had in a month or a year or how high or low the churn rate is for a specific period; all it does is tell you how much money entered or left your business.
Accrual accounting is an accounting-based system that records financial transactions, both revenue and expenses, at the time the transaction actually took place. This accounting method is not concerned with whether or not you’ve been paid or you’ve paid for the said transaction. It only records when the revenue is earned and when the expense is incurred.
So, if your business renders its services to a client by February and the client pays for the service rendered by May, the record dates back to when the revenue was incurred, and that was February. It doesn’t bother about when the money was paid.
And just like Forbes said in their financial glossary regarding accrual accounting, “cash does not need to change hands before revenue is recognized,” which is the main principle it sticks with.
Accrual Accounting Advantages
Measure business performance and financial health:
Accrual accounting gives you an insight into how your company is fairing in the long term. It gives you an overview of what the monthly recurring revenue is, the churn rate of your customers, and the overall performance of your business, whether it is growing or not.
Help make growth decisions:
You can make accurate growth decisions with the records you have in your accrual accounting system. Since it already tells you what’s going on with your business and where it stands currently in the face of growth, you can easily proffer a solution or develop a strategy, if necessary, to help your business.
Accrual Accounting Disadvantages
Requires more time and resources:
To effectively record and carry out business dealings with accrual accounting, you need more time and resources. As a result, small businesses gear towards using cash accounting because they cannot afford the time and resources required.
Complicated to execute:
Accrual accounting is more complicated to manage. You may or may not require certain skills to be able to record with this recording system. To avoid any mishaps due to complications, some companies stick to the cash accounting method. However, the benefits that accrual accounting brings are not easy to let go of, and as such, most SaaS companies stay with this record system.
Which Account Method is the Best for SaaS?
After considering all factors, experts have concluded that accrual accounting is the best accounting method yet for SaaS companies. The accrual accounting method features both your SaaS business growth and your financial audit (monthly and yearly), two of the critical criteria for every SaaS business that the cash accounting method cannot accomplish.
The accrual accounting Method allows you to capture your recurring revenue, monthly and annually, and also how your customers are behaving in the short or long term. With this accounting method, your SaaS business can stay ahead because it gathers all the necessary information in its account.
How to Change from Cash Accounting to Accrual Accounting?
A dilemma that most SaaS companies face is switching from cash accounting to an accrual accounting method. Although the process is not easy, it is not undoable. To be able to switch effectively, you should indulge in the following steps:
- Review and add back all accrued expenses; this would include work materials and goods received but unpaid for, wages/salaries earned but unpaid or services employed but unpaid.
- Subtract payments/receipts for expenses that should have been settled/paid for the previous accounting period.
- Subtract prepaid payments for clients that have been paid in advance for their services and record them as short-term liabilities until the service is rendered.
The Intrepid Finance team can help you with calculating your MRR and ARR. Check out our free calculators and resources that have helped SaaS businesses worldwide gain a better understanding of their recurring revenue. To learn more about it, reach out to us via intrepidfinance.io!