As an entrepreneur launching your new SaaS business, there are countless decisions you’re called upon to make. One of them is choosing which way to do your accounting.
There are different approaches you can take, depending on the nature of your business. And once you select the one that makes sense for your company, you need to be clear about what you’re doing and be sure to follow Generally Accepted Accounting Principles (GAAP).
All of this can seem a little overwhelming and confusing. We’ll walk you through the basics to help you get started.
Cash vs. accrual accounting
Cash accounting and accrual accounting are the two main ways you can approach your financials. One of the biggest distinctions between the two is at what time you recognize revenue.
Cash accounting offers the easiest way. You simply recognize the revenue at the time you receive the payment. However, in some situations, cash accounting can lead to problems when the payment you receive does not come at the same time as the goods or services you provide. For example, you may sell a product or service and be waiting for payment, or you may receive payment for a subscription to a service that you provide over time. In both of these cases, it’s not possible to match income and expenses when you use cash accounting.
With accrual accounting, revenue can be recognized at one of three times:
When cash is received (if the timing aligns with the goods or services provided),
At the time that the goods or services are provided, even though the actual cash will not be received until some point in the future; or
Spread out over future points in time in situations where payment is received upfront and the service is provided over time (this scenario is known as deferred revenue).
Although accrual accounting is more complicated, it allows SaaS businesses to recognize revenue at the time when cash income lines up with the expenses incurred to generate that income.
Deferred Revenue Basics for SaaS Startups
Deferred revenue is the accounting strategy used in accrual accounting when you do not recognize revenue immediately upon receipt, but instead recognize that revenue over time.
For SaaS businesses that are selling pre-paid subscriptions with services rendered over time, much of the revenue may be deferred, and using accrual accounting rather than cash accounting makes the most sense.
According to GAAP, deferred revenue is a liability related to a revenue-producing activity for which revenue has not yet been recognized. Therefore, a company should record deferred revenue as a liability in the balance sheet when it receives payments from clients for products or services that have not yet been delivered or rendered.
An important thing to remember is the cost to service the deferred revenue. Since you have already received upfront payments for future services, you will have future cash outflow to service the contract in the future but no additional cash inflow, so be sure to plan accordingly when making long-term contracts that are paid for upfront.
How to debit and credit deferred revenue
For example, let’s say a software company signs a three-year maintenance contract with a customer for $48,000 per year. The company gets paid $48,000 upfront annually on January 1st for the maintenance service for the entire year.
On January 1st, after the company receives cash payments from the customer, the company should debit (increase) $48,000 in the cash account and credit (increase) $48,000 in the deferred revenue account.
As time passes and services are actually performed, the company should debit the deferred revenue account and credit the revenue account. For instance, on February 1st, the company should credit $4,000 in the revenue account ($48,000/12 = $4,000) and debit $4,000 in the deferred revenue account to show that services have been performed and revenue has been recognized for the period from January 1st to January 31st.
A common accounting mistake
An error made by many entrepreneurs is to offset deferred revenue with accounts receivable. Some companies record the entire contract value in accounts receivable and deferred revenue to show the potential economic impact of future contracts on the present value of the business. This is not in accordance with GAAP.
Deferred revenue should not be used as a double entry account along with accounts receivable to reveal contract values.
Investors like Lighter Capital, venture capitalists, and angels will take contracts with customers into consideration when evaluating the value of the company, although your bank probably won’t do so.
At Lighter Capital, we see financials presented in all sorts of different forms: accrual, modified accrual, and cash. We are always open to working with all of these forms of accounting, but it’s a good idea to know what form you are using and why — and it's essential that you follow GAAP standards no matter what you do.