Finance teams need to decipher the specifics of SaaS accounting to ensure they're reporting and forecasting properly - not to mention complying with Financial Accounting Standards Board (FASB) and International Financial Reporting Standards (IFRS) regulations and relevant tax laws.

What is SaaS accounting?

The growth of the industry has been accompanied by significant changes in SaaS Accounting Software. Among the most recent - and most consequential - are ASC 606 and IFRS 15.

The FASB's ASC 606: Revenue from Contracts with Customers replaces the rules in ASC 605: Revenue Recognition, while IFRS also amended its guidance to better (but not exactly) align the FASB rules 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 should be recognized over the life of the service subscription, rather than when they are received or incurred.

Common challenges with SaaS accounting.

Despite the robust framework provided by FASB and IFRS regulations for recognizing revenue and expenses, SaaS providers face additional accounting hurdles. These challenges can create significant financial reporting issues, risk non-compliance with state, federal and international tax and other rules and regulations, and make determining numbers like customer lifetime value (CLV) a complex task for finance teams.

Let's look at three specific SaaS accounting challenges.

Recognizing the right time to recognize revenue.

The most common - and biggest - challenge for SaaS companies is identifying the right time to recognize revenue. Because the customer never gains "control" of the good or service, the general rules of revenue recognition do not apply. Instead, under FASB rules, SaaS companies must recognize a majority of their revenue over the life of the contract in most cases. This is true whether the SaaS provider receives the entire amount for the service upfront or uses a weekly, monthly, quarterly or annual subscription model.

Know How to Manage Spend

SaaS providers also need to spread out many of their expenses over the life of the contract or the estimated life of the customer relationship. It's important to know which expenses need to be amortized and which can be expensed immediately. Like revenue, the SaaS company must also recognize certain expenses at certain points in time.

Collecting sales tax

Managing sales tax is another major challenge for SaaS providers, who often have employees in remote locations and whose operations and revenues span multiple states. While SaaS companies are not always required to collect sales tax on their services, some states do tax software in some or all service categories. SaaS companies are responsible for sales tax regulations in the states where they have nexus.

How to handle SaaS taxes

SaaS providers need some specialized accounting knowledge to avoid costly mistakes. Taxation is one of the most complex areas and carries the potential for significant penalties.

SaaS companies and sales tax

Because there is no physical software and SaaS companies are web-based, the question of when to collect sales tax is complicated. Even more confusing is that in some states, SaaS companies do not have to collect sales tax, but cities in those states do, such as Illinois and the City of Chicago.

Complicating matters further, SaaS companies that operate in multiple states must follow "nexus" rules to determine whether they must collect sales taxes. While the basic definition of "nexus" means having a "substantial physical presence" in a state, Internet-based commerce has caused the interpretation of this concept to change.

Accrued and deferred expenses and revenues.

Accounting rules require SaaS companies to allocate many of their expenses over the contract term or the estimated duration of the customer relationship, whichever is longer. There are specific rules for what expenses SaaS providers can defer and how they should handle certain expenses, such as sales commissions.

Expenses, commissions and revenue

Most SaaS vendors use the accrual method of accounting, which means they recognize revenue when a purchase transaction is made, not when the money is received.

The key is to accrue these expenses and record them in proportions that correspond to the revenue item to which they are allocated. For example, for a $1,200 commission on a 12-month customer contract, the commission would be split into 12 equal amounts of $100, with $100 removed from the liability side of the balance sheet and added to the assets that will be reported on the income statement when it is recognized.

5 Steps to Revenue Recognition on the SaaS Balance Sheet.

ASC 606 provides a five-step framework for revenue recognition. These guidelines outline the appropriate steps to take to recognize revenue and eliminate inconsistencies and ambiguities in SaaS accounting.

1. Identify the contract with a customer: Organizations follow this step when signing up new customers for the service.
2. Identify the performance obligations of the contract: In this step, the provider must ensure that the contract explicitly states the services to be provided, the duration of those services (contract term), and the obligations and rights of the customer and the SaaS provider. This includes listing the services to be provided and the obligations.
3. Determine the transaction price: this is the amount the provider expects to receive for providing the contracted services. This amount includes the total of all individual services and bundled services, as well as any discounts.
4. Allocate the transaction price: this step requires the allocation calculations from the previous section. Since most SaaS companies operate on an ongoing subscription basis, the allocation period for longer contracts, such as 12 months or more, can be broken down for collection purposes. This calculation is often 30 days, as this is the smallest billing cycle for most SaaS vendors.
5. Recognition of revenue when performance obligation is fulfilled: In this final step, SaaS companies recognize revenue when they fulfillthe performance obligations and the customer benefits from the service or services.