SaaS Accounting Tips
SaaS accounting is probably not every SaaS founder’s favorite topic. However, as you scale, it is critical that you implement an accounting framework that will provide you and your team the necessary data to manage your business. In this post, I offer several actionable SaaS accounting tips for founders and their accounting teams.
When Should Accounting be a Focus?
Always (I’m biased, of course), but….in speaking with SaaS founders about the challenges they face in understanding their SaaS economics from the reporting side, it usually boils down to how they have set up their accounting system. This is understandable. Early in a startup’s life, you are more concerned about product/market fit (Phase 1 per David Skok), watching cash balances, and producing basic financials for your tax accountant.
You don’t really have enough customer and financial data to produce accurate and meaningful SaaS metrics. As you scale, though, this data becomes more important and is necessary to manage your performance.
What’s the ARR Tipping Point?
It appears to me that the $1-2M ARR point is a good time to take a look at your accounting and financial reporting process.
As you scale past $1M in ARR and enter Phase 2 (scalable business), you are now thinking about adding sales and marketing heads, for example, and its impact on your financials, metrics, and cash. Without a proper accounting framework, it is very difficult to calculate these metrics.
Before you can calculate these metrics, your financial data must be coded correctly to your general ledger (GL). Now is the time to review your chart of accounts with your accountant or advisor.
Chart of Accounts (COA) and Expense Coding
A chart of accounts is simply an organized listing of the general ledger accounts in your accounting system. There are general ledger accounts for your balance sheet (i.e. 10000 – Cash) and your P&L (i.e. 40000 – Subscription Revenue, 60000 – Employee Wages).
Each month your bookkeeper or accountant is posting journal entries to these accounts so that you can produce financial statements. However, what I find is that most early-stage SaaS companies are not coding expenses to the department level (i.e a cost center). Posting expenses to a GL account AND department or cost center is critical to produce the reports that will help you understand the economics of your business.
Without department level coding, you don’t know how much wage expense you have in sales versus your development department, for example. Without this, you cannot accurately calculate SaaS metrics, because your expenses are sitting in one big bucket.
I like to see the following departments in your chart of accounts. When you code expenses to these departments, you will have enough data to calculate metrics relevant to your business, and you’ll be able to assemble proper financial forecasts. You’ll also be able to compile what I call a “software P&L.” Also, without department coding, it’ll be very difficult or impossible to calculate your overall gross margins and gross margins by revenue type.
- Field Services
- Customer Success
- Technical Support
- Cost of Operations
- Corporate Administration (HR, accounting, executives)
What about Revenue?
I’m more flexible on how you should code revenue, but you need to be able to differentiate between subscription and service revenues. You also need to differentiate revenue by product line.
The distinction between subscription and service revenues is typically handled by unique GL revenue accounts. For example, 40000 – Subscription Revenue, 41000 – Field Service Revenue. To handle product line revenue, you could create another GL account (40000 – Product A Subscription Revenue, 40010 – Product B Subscription Revenue).
Another approach to product revenue coding is to code revenue to a profit center, a department reserved for revenue entries (opposite of a cost center or department expense coding), along with the relevant GL account.
Then, there is no need to create multiple subscription revenue GL accounts. You just need to code Product A revenue to 40000 – Subscription Revenue and to Product A’s profit center. Your reporting and analytics will be much cleaner and easier.
If you are a SaaS business with $1-2M in ARR, your key takeaway is to ask your bookkeeper or accountant if they are coding expenses to the department level. And if you are, great! Then ask what departments are being used.
Without the proper SaaS accounting framework, you’ll be running blind as your business becomes more complex. Even the best financial analyst wouldn’t be able to produce meaningful SaaS metrics and financial forecasts from one bucket of expense data.
But you have a chance to start now, and before you know it, you’ll have six months of historical data that will provide amazing insight. If you have any questions, please post them below or contact me.