SaaS Accounting: Cash or Accrual?

As part of my job at saas.group, I review financials of small SaaS companies almost every day. A recurring problem I observe is that many of them outsource their accounting to a bookkeeper or accountant who doesn’t know anything about SaaS.

One common theme among these companies is that they use cash accounting instead of accrual accounting. There's nothing wrong with that per se, but accrual accounting is far better suited to the SaaS business model. Here's why:

Understanding Cash vs. Accrual Accounting

Cash Accounting records revenue and expenses when cash changes hands.

For example, if you receive a $12,000 payment for an annual subscription in January, you recognize the entire amount as revenue in January, regardless of the service delivery period.

Accrual Accounting, on the other hand, records revenue when it’s earned and expenses when they are incurred, regardless of when cash is received or paid.

Using the same example, the $12,000 payment would be recognized as $1,000 of revenue each month over the year, aligning revenue recognition with service delivery.

With more customers and different contract / payment intervals, it will probably look a bit like Todd Gardner's example below.

As you can see, cash accounting creates quite some noise in the revenue trajectory which makes it difficult to identify underlying trends.

Pros and Cons of Each Method

Cash Accounting

Pros:

• Simplicity: Easier to implement and understand.

• Immediate cash flow visibility: Reflects actual cash in hand, useful for short-term planning.

Cons:

• Misstated figures: Does not match revenue with the period it was earned, leading to potential misinterpretation of financial performance.

• Limited scalability: Becomes cumbersome as the business grows and transactions become more complex.

Accrual Accounting

Pros:

• Accurate financial picture: Matches revenue with the period it is earned, providing a true reflection of financial health.

• Investor readiness: Preferred by investors and required for GAAP compliance.

• Better decision-making: Facilitates detailed financial analysis, essential for strategic planning and forecasting.

Cons:

• Complexity: More complicated to implement and maintain.

• Requires expertise: Often necessitates experienced accounting support - from someone who is familiar with SaaS.

Why Accrual Accounting is Better for SaaS

1. Revenue Recognition: In SaaS, businesses typically operate on subscription models where services are delivered over time. Accrual accounting ensures that revenue is recognized as it is earned, providing a clear picture of monthly recurring revenue (MRR) and annual recurring revenue (ARR). With Cash Accounting, MRR and ARR can’t be tied to the income statement and need to be calculated separately (= more error-prone). It also makes it more challenging to measure KPIs such as CAC metrics, Gross/Net Revenue Retention etc.
   

2. Expense Matching: Aligns expenses with the revenue they help generate, offering a more accurate view of profitability. This is particularly important for SaaS businesses that may have significant upfront costs for customer acquisition and product development. In addition to incorrectly calculated KPIs, the misrepresentation of profitability with cash accounting is often a big point of discussion in M&A talks.
   

3. Investor and Compliance Requirements: Accrual accounting is required for GAAP compliance, which is often a prerequisite for attracting investors in late-stage rounds (Series A and beyond), or at the latest for an IPO if you make it that far. From experience, it also makes a better impression in exit discussions and makes it easier for a potential acquirer to calculate typical SaaS KPIs and assess the company’s financial health.

Conclusion

While cash accounting might be tempting for its simplicity, in SaaS, accrual accounting provides a more accurate and comprehensive view.

By adopting accrual accounting from the start (or switching to it asap), you set a solid foundation for growth, compliance, and strategic decision-making.