You’re probably here because you have to convert your books from cash to accrual. You’re making the switch to improve your board meetings with investors, get through an annual financial statement audit, complete your series A financing, or for an IPO.
Yes. Seeing the cash-in and cash-out every month is reassuring, but you’re making the change in accounting method because your company’s growth depends on it.
You are familiar with the pros and cons of cash versus accrual accounting.
How do you switch a Software as a Service (SaaS) from cash to accrual? Glad you asked!
We created the playbook on switching from cash to accrual accounting specifically for growing SaaS SMBs like you. Our playbook takes you through the process step by step.
We know that each CEO is unique. At inDinero, we answer your questions, but, more importantly, we address your concerns about transitioning the financial system that has helped you get this far. When it comes to converting your company’s books and setting up a way to recognize revenue that works for you, we are the experts—your experts. As an accounting SaaS, we know from experience the value of accrual accounting for your business operations and strategy.
At the end of the day, you want to know how an accounting methodology that sounds like more time (i.e., double-entry) and expense is of value to your future success?
Why recurring revenue needs double-entry bookkeeping
The accrual method is preferred by investors and business analysts, but what’s in it for your business? Rapidly growing SaaS companies want these three things from their financial reports:
- Insight
- Clarity
- Confidence
I’m not a financial wizard, but with two squares, I can show you why accrual is better than cash for your growing SaaS business.
These two squares represent your company’s monthly recurring revenue. When you look at the bigger square, can you see how or when growth occurred? The cash method of accounting can tell you what is growing or shrinking but not when and how the growth happens.
Thankfully, SaaS and accrual accounting are simpatico.
SaaS customers subscribe for the right to use software and service (i.e., maintenance, support, and updates) for a given period (usually a year). The revenue is recurring, and fees collected monthly, quarterly, or annually. Some subscription businesses use pay-as-you-go, term subscriptions, or subscriptions paid upfront to use their software and services. The accrual method can capture all manner of recurring revenue and assign the cost of goods and services to the same period and services for a clear picture of your financial position.
Accrual accounting has been around since the 15th century for a reason
Croatian Benedikt Kotruljević first described double-entry accounting in his Book on the Art of Trade, published in 1458. As a point of comparison, the subscription business model came about in the 17th century with the rise in books and periodical distribution. As SaaS revenue streams have become more flexible, double-entry bookkeeping has remained integral to running a subscription business model. A chief reason for that is the matching principle, a rule for recording expenses in the same period that related revenues are earned on the income statement. The expense then becomes a liability on the balance sheet for the end of the period. Tying revenue to costs of goods sold shows you how and when an expense (i.e., payroll) relates to revenue in an accounting period. With an accrual method of accounting, SaaS gets insight, clarity, and confidence.
Limitations of cash accounting for SaaS
The four most common reasons SaaS companies switch from cash to accrual accounting are:
- Investors want to see accrual-basis financial statements (balance sheet and income statement),
- Generally accepted accounting principles (GAAP) compliance is required for public companies,
- A financial statement audit, and
- A series A investment round.
On the flip side, there comes the point when SaaS CEOs come up against the limitations of cash basis. These limitations are:
- It can’t track monthly recurring revenue (MRR).
- It strictly records revenue when cash changes hands and blurs cash flow.
- It doesn’t account for liabilities and assets within an accounting period making it tough (if not impossible) to see trends in your business performance.
Next up, let’s get into the limitations of cash accounting for SaaS.
Limitation of cash accounting to recognize revenue for SaaS
To illustrate how cash accounting doesn’t meet my “insight, clarity, and confidence” threshold, let me tell a story. It’s a story about ESL-U. They developed an English-as-a-Second Language learner app, offer e-tutoring and a conversation-partner match.
The first day ESL-U released its free app, it had 1,000 downloads. Premium subscribers enjoy an ad-free experience and gain access to skilled ESL-U tutoring and friendly language exchange partners. The premium price is $34.99 a year. ESL-U accepts one payment of $34.99 or a monthly electronic debit or charge to a credit card of $2.91 plus service charge. ELS-U sold 200 premium subscriptions on their first day.
ESL-U’s founders have been borrowing from their parents and working part-time to scrape by. The last thing they want to do is spend their first revenue on accounting software. Like scrappy entrepreneurs, they track their revenues and expenses on a free pre-formatted spreadsheet that uses the cash method or single-entry bookkeeping. It might look something like this:
According to cash accounting, ESL-U’s revenue is what’s in the bank. The revenue for ESL-U looks like this:
| Revenue | Received |
| Cash | $34,990 |
| Other Income | $0 |
The founder of ESL-U is ecstatic to be profitable and is already thinking about how they’re performing. To determine ESL-U’s performance, they’ll need to know their expenses.
The operating expenses ESLU using the cash method of accounting are:
| Expenses | Paid |
| Fixed Costs | $1,500 |
| Payroll Costs | $4,000 |
| Loan Payments | $0 |
Now, let’s add some complexity. ESL-U fell short of its goal for the first month. ESL-U plans to reinvest its monthly profit to boost sales. How much do they have to spend? Do they need another family and friends funding round? Let’s see.
In the first month, ESL-U’s first-month transactions were as follows:
- Sent monthly invoice to 5,000 premium subscribers, totaling $14,550,
- Added 1,000 annual premium subscribers, totaling $34,990.
- Received an invoice for $2,000 from a UX contractor at the close of a project.
- Paid $100 for insurance.
- Paid $1,100 in rent for the month.
- Paid $300 in utilities for last month.
- Cut paychecks totaling $4,000.
Using the cash method, ESL-U’s profit for the month is $29,490 ($34,990 in annual subscription payments minus $5,500 for payroll, rent, insurance, and utilities). The calculation is simply profit = cash in – cash out.
Using the accrual method, ESL-U’s first-month profit is $10,265. The difference between the accrual and the cash profit numbers is that accrual takes the revenue from the first 1,000 subscriptions and spreads it across the 12-month contract period.
Here’s how you get to $10,265 profit for the first month with accrual:
- 1,000 subscriptions at $34.99 each equals $34,990. Recognized across 12 months = $2,915 (annual total for one month)
- Add the monthly invoice total: $14,550 + $2,915 = $17,465
- Subtract all expenses: $17,465 – $7,200 = $10,265
SaaS revenue can be tricky. A CEO wants to see higher revenue and needs insight into their revenue, clarity on their profit, and confidence in their financials to make savvy decisions.
For example, monthly recurring revenue (MRR) is a crucial metric for SaaS. MRR is equal to the total revenue less non-recurring revenue. It is an essential metric for SaaS to understand how sales are progressing or lagging behind expectations. The ESL-U example shows two very different pictures of the company’s monthly revenue. Many CEOs struggle with seeing their revenue from the accrual perspective. The trick is to look at how revenue relates to expenses.
If our friends at ESL-U continue to use the cash method of accounting, their cash flow and the costs of goods and services will be blurred by the business’s bank balance.
Protip: Learn more about the importance of revenue recognition and the ASC 606 guidelines for public companies issued by the FASB in 2014.
The moral of the ESL-U Story: Accrual accounting is good for SaaS
Recall the black-box quality of cash-basis recurring revenue April and May squares.
In your imagination, turn those squares into three-dimensional cubes comprised of smaller cubes, each representing a transaction. Now, color code those transaction cubes and line 12 of them up. Next, look for the MRR cubes. Can you see it with your mind’s eye? Then, my friends, you’ve got yourself greater insight, clarity, and confidence.
I hope it’s clear that your accrual accounting financials can tell you so much more about your business: monthly recurring revenue, your cash flow, your acquisition costs, and the profitability of your company overall.
Next, we’ll get into the process of converting from cash to accrual accounting.
Converting to accrual accounting in six steps
Accounting is not your thing; business is your thing. That said, it’s helpful to know what to expect when converting from cash to accrual accounting.
We strongly recommend that you do not attempt to do this yourself. inDinero’s accounting experts are here to help you.
How does YOUR revenue work?
You know your business better than anyone else. That’s why for a data-heavy project like this, knowledge transfer is one of the most critical steps to switching to accrual-basis accounting. inDinero works closely with you to make sure that they understand how your revenue (and your expenses) work.
inDinero customers work with a controller who leads your inDinero accounting team and will be your primary contact.
Converting revenue and expenses to accrual takes time
Your accounting team will collect transaction data going back to the start of the fiscal year. They will need to review each transaction to create the business financial reports investors want to see and build your specific revenue recognition process.
Six steps to convert your books from cash to accrual:
- Review and book all accrued expenses.
- Subtract cash payments for wages and invoices that should have been recorded in the previous month (aka accounting period).
- Account for and record prepaid expenses. An example of a prepaid expense is insurance.
- Add accounts receivable, which represent sales or bills issued.
- Reverse cash receipts for sales incurred in the previous accounting period and adjust the current month’s net income or loss.
- Subtract customer prepayments and record them as short-term liabilities.
Hopefully, you have a better understanding of why investors want to see your financials on an accrual basis. The accrual accounting method provides more immediate insight into what is happening with revenues and expenses in any given period.
Why would you—the business owner—want to see things this way?
What’s in accrual accounting for SaaS CEOs?
If you struggle to handle tremendous growth (in sales or inventory), accrual accounting will help you manage. Consider these advantages:
- Accrual is better for knowing where your money is going. When you know your expenses, you can set the best price for your products or services.
- Accrual provides a better way to track payments and their corresponding benefits. Remember that professional association that you never get around to and costs $1,000 a year? Accrual can help you identify and cut out wasteful spending.
- Are you falling behind with accounts receivable? Are you paying late fees? Accrual accounting provides the consistency and clarity you need to prevent overpaying and take action on AR.
- When you use cash accounting, you can misrepresent revenues (not record deposits) and expenses (show payments after they happened), leading to risky financial practices.
We can’t close on accrual accounting without mentioning its effect on SaaS business taxes.
Let the IRS know about the switch in your tax accounting method
The IRS doesn’t care what accounting method that you use (usually cash or accrual) to manage your business. The method is meant to be useful to a business owner, management, and investors. You can switch from cash to accrual to better manage your business and leave the IRS out of it.
The IRS cares about the tax accounting method used to file your return. It’s true that when a company reaches a threshold in revenues or inventory it’s required to be GAAP compliant.
Protip: Do not confuse GAAP for an accounting method. Accrual accounting is the GAAP compliant accounting method used in the U.S.
Regardless of these thresholds, if your business’s tax accounting method changes, you need to file the Form 3115, the Application for Change in Accounting Method. inDinero can help with filing your Form 3115 in a manner that is timely and correct.
For more on how business tax deductions and credits work for your young company, read our post about the advantages of GAAP compliance for small businesses.
Are you ready to see ROI on your monthly management reports? inDinero has the right mix of industry, tech, accounting, and tax expertise to make accrual accounting work for your business? You’ve got the playbook. Now, schedule a call with our experts.
Quick Note: This article is provided for informational purposes only, and is not legal, financial, accounting, or tax advice. You should consult appropriate professionals for advice on your specific situation. inDinero assumes no liability for actions taken in reliance upon the information contained herein.
