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While companies are a bit more free to perform bookkeeping according to their own needs, accounting is a very organized and rigid discipline. While that can make it daunting at first—with so many rules and regulations to follow—as you become familiar with them, it takes all the guesswork out of the process. We are going to look at two of those principles here: the matching concept and the revenue recognition concept.
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The matching principle and the revenue recognition principle are the two main guiding theories underlying accrual accounting. They are defined in U.S. GAAP (Generally Accepted Accounting Principles) and should be used by any entity following the accrual accounting system.
Matching concept: This principle stipulates that accountants should record all revenue and expenses in the same reporting period. This means that expenses should be matched to the revenue they generate and therefore be shifted into the period in which the revenue was earned instead of being recorded in the period they were paid for.
Revenue recognition concept: This principle refers to the period and manner in which a company realizes its income. A company should recognize revenue in the period in which it was earned, and not necessarily when the cash was received.
For a subscription SaaS provider, this can mean breaking up the money received from an annual subscription into the monthly periods as the services are provided. This provides auditors with a so-called apples-to-apples comparison of a company’s financial picture that is more transparent across industries.
Accrual Accounting vs. Cash Accounting
Accrual Accounting Method
In the accrual accounting method, revenue is accounted for when it is earned. This usually will happen before money changes hands, for example when a service is delivered to a customer with the reasonable expectation that money will be paid in the future. Expenses are similarly recognized when they are incurred.
This is done by following the matching principle. Accrual accounting entries require the use of accounts payable and accounts receivable journals, as well as a few others for deferred revenue and expenses, depreciation, etc.
In the cash accounting method, revenues and expenses are recognized when cash is transferred. This is the system used by individuals when budgeting household expenses and by some small businesses. The matching concept or revenue recognition concept is not used in the cash accounting method.
Matching Concept Examples for SaaS Accounting
According to many tax authorities, SaaS companies must use the accrual accounting system, which stipulates that you record revenue when it is earned, i.e., the revenue recognition principle.
In the case of a subscription revenue stream, this means when you have fulfilled your part of the service agreement.
Consider the following two subscription revenue examples to make this point clear.
1. Your company offers a discount to clients that pay their bill annually instead of monthly. You have 10 clients that take advantage of the discount. These invoices total $90,000.
Since you must provide services to these clients for an entire year and your income statements are drafted monthly, U.S. GAAP standards stipulate that you should move $7500 at the end of each period into your revenue account and keep the remaining unearned subscription revenue in a deferred revenue account as you have not yet earned the money.
2. Your company bills clients at the end of the month for the services you’ve provided during the month. Most of your clients pay within the allowed time period, but some—due to issues with the payment system, a forgetful manager, the invoice hitting the spam folder, etc.—do not pay on time.
In this case, even though you are earning $7500 at the end of each month, you may not be receiving all of it until some days, weeks, or months later—or, unfortunately, sometimes not at all. In this case, you still recognize the revenue of $7500 each month using an accounts receivable journal entry and then later move the revenue to your cash account when you receive the payments.
In the first case, you have more cash on hand than your company has actually earned. In the second case, you have less cash on hand than you have earned, and you might not even receive all the money you have earned.
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The same is true for expenses: they must be recognized when they are incurred regardless of when the invoice is paid. This is done by matching the expenses to the revenue they generate where possible.
When this is not easily possible, then either the systematic and rational allocationmethod or the immediate allocation method can be used. The systematic and rational allocation method allocates expenses over the useful life of the product, while the immediate allocation method recognizes the entire expense when purchased.
Let’s consider a few examples for when expenses should be recognized.
1. You decide to advertise your new SaaS product on Twitter. You set a budget of $12,000 to hit your targeted market over a four-month period and pay the invoice. Since you draft monthly income statements, you divide the $12,000 into four monthly expenses of $3000 and recognize them over the four consecutive monthly periods.
2. You spend $25,000 on new office furniture. It is expected that these items will last five years and have no residual value for resale. Instead of recognizing the entire $25,000 in the first year, you should list the assets on your balance sheet and use a depreciation expense to claim $5000 per year on your income statement.
3. You spend $2500 to host a party to launch your new SaaS product. Since this party cannot be matched to any individual sale, it can be recognized under the immediate allocation method as an expense in the period it was paid.
Applying the Matching Principle to Financial Statements
The matching concept and revenue recognition concept affect the various financial statements in different ways. Let’s look at how these two principles affect the income statement, balance sheet, and cash flow statement with a simple exercise.
Consider the following set of information. You purchase inventory in Year 1 with cash. The inventory is then sold on credit in Year 2. The customer then pays the amount owing in Year 3.
The purchased inventory affects the Cost of Goods Sold (COGS). The sale of the inventory to the customer affects the revenue. Even though the customer doesn’t pay until Year 3, the sale was made in Year 2, so we should record the revenue earned in Year 2 according to the revenue recognition principle. Then, according to the matching principle, since the inventory purchase should be matched to its sale, even though we paid cash in Year 1, it should also be recognized under COGS in Year 2.
Inventory is considered an asset, so it shows on the balance sheet. Similarly, cash is also an asset and shows on the balance sheet. In Year 1, the balance sheet will show an increased value in inventory and a decreased value in cash (which is sometimes called “cash and cash equivalents”).
Then, in Year 2, the inventory will show a decrease while the accounts receivable shows an increase from the sale. Finally, in Year 3, when the customer settles their bill, accounts receivable will show a decrease, while cash will see an increase.
Cash Flow Statement
The inventory was purchased using cash in Year 1. This is shown as a negative cash flow, i.e., a decrease in the cash account. In Year 2, the inventory was sold on credit, which doesn’t change the cash flow. Finally, in Year 3, when the customer pays for their purchase, it is recorded as a positive cash flow.
There are two key takeaways from this simple example. First, the two transactions occurred over three years in reality, but both are used in the same middle year for the income statement (and therefore taxes).
This can be problematic without proper planning, since you would be out cash in Year 1 to the supplier of your inventory and out the taxes owing in Year 2 for the revenue, but you won’t receive any cash until Year 3 when your customer settles their bill.
Second, since large and complex businesses recognize revenue and match expenses independently of cash flow, keeping track of the cash position of the company is more difficult than it would be otherwise.
Producing high-quality cash flow statements, monitoring customers closely to make sure they pay as soon as possible, and tracking any and all metrics of your company are immensely important tasks to prevent a cash crunch.
This is a lot to take in at once, but with practice you’ll be able to quickly deduce when and where your revenue and expenses need to be reported. Good financial statements are the heart of any business, and keeping them in order is a surefire way to keep tax authorities happy.
Having a system that can automatically segment your customers and report your revenue over specified periods makes these concepts a breeze to follow. That’s where Baremetrics comes in.
Baremetrics can integrate directly with your payment gateway, such as Stripe, and visualize the information about your customers and their behavior on a crystal-clear dashboard.Baremetrics brings you metrics, dunning, engagement tools, and customer insights. Just a few of the metrics Baremetrics monitors are MRR, ARR, LTV, the total number of customers, total expenses, and Quick Ratio.
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