Software-as-a-service (SaaS) companies are driving fundamental changes not just in technology, but also in the landscape of financial reporting. So, what is their link to accounting standards, and why does it matter?​

​

SaaS versus perpetual licensed software

 

Traditional software products provided by companies like Oracle or SAP offer a perpetual license model to use the software in exchange for an upfront license fee and a recurring maintenance fee. Customers own the software infinitely once they install it on their hardware and can customise it.​

 

However, SaaS products sold by companies like Salesforce or LinkedIn are delivered over the Internet on a subscription basis. The main difference is that instead of purchasing a license, which gives the customer the right to use the software in perpetuity, SaaS companies provide customers with the right to sign up and use the software on an ongoing basis. The vendor owns and manages the software. These applications are usually cloud-hosted, which gives them the name of cloud software or hosted software.

 

When business model impacts financials

 

The difference in business models has a direct impact on the financials of SaaS companies. In contrast with perpetual software providers, SaaS companies do not receive an upfront fee for their products. Instead, they only recognise the revenue when the software is delivered. For instance, in the case of a twelve-month contract, they receive 1/12 of the contract value each month. However, their expenses reflect the implementation costs required since the day they signed the contract. The income statement of SaaS companies thus suffers from the misalignment between the timing of revenues and expenses.

​​

Therefore, for SaaS providers, even more than for any other business model, the income statement alone does not paint the whole picture of the actual profitability of the business. It can harm the company's financial performance, at least in the short run.​

 

The graphs below illustrate a very simplified comparison of the cash flows between a licensed software provider (left) and a SaaS provider (right), both with an initial cost of $10,000. This is often called Customer Acquisition Cost (CAC) and includes the costs of research and development, marketing, etc.

​

​

​

​

​

​​

​

​

​​​While the licensed software provider will cover the initial costs in month two from the upfront license fees of $18,000, for instance, the SaaS provider will only see 1/12 of the total $18,000 subscription fee (or $1,500) in month 2, followed by the same amount throughout the twelve-month agreement.

 

We made some rough assumptions to make the two business models like-for-like: there is no margin, both models are single-customer, and the license cost is equal to the subscription fee for the SaaS provider.

​

The different accounting standards collide

 

In addition to the business model itself, the accounting standards governing the preparation of financial reports also contribute to how investors and shareholders perceive the financial performance of software providers.

 

In Europe, since 2005, public companies have applied the International Financial Reporting Standards (IFRS) adopted by the International Accounting Standards Board (IASB), following EU regulations. However, SaaS providers claim that IFRS does not offer clear guidance about reporting subscription revenues.

 

Hence, they must turn to U.S. Generally Accepted Accounting Principles (U.S. GAAP), adopted by the Financial Accounting Standards Board (FASB) in 2014. Under U.S. GAAP, revenues from software development are reported only when the development is complete and the customer receives the software.

 

Therefore, SaaS companies can operate at a loss until the software is delivered to the first customer or break even if they manage to secure funds from venture capitalists. To realise profits, SaaS providers often need to ask for payment in advance or carefully time the acquisition of new customers with the delivery of their software products.

 

Although the two accounting standards, IFRS and U.S. GAAP, have not functioned separately, a converged standard was issued in May 2014 to provide more coherent guidelines on revenue recognition from customer contracts.

 

The joint standard applies to financial accounts filed on or after the 1st of January 2017 and requires companies to capitalise on incremental customer acquisition costs (CAC) that meet specific criteria rather than expense them.

 

The change in accounting standards comes as a natural outcome based on the industry's needs. It will revolutionise the landscape of financial reporting for many businesses, not just for software providers, and it will require a sensible judgement on reporting revenues.