When a customer pays for a service upfront that won’t be delivered until later in the future, the company does receive the cash. But the revenue generated from the advance payment cannot be marked as earned — at least not until the service has been rendered. This unearned revenue is called deferred revenue. Deferred revenue is very common in the world of Software-as-a-Service. It can be a little tricky to grasp, and even trickier to manage. But if done right, it can also be a tool for growth and success.
Although deferred revenue adds to the cash flow, it’s technically a liability because the advance payments create a legal obligation for the company to deliver the promised services.
Once the services are rendered for a specific period, that portion of the prepayment can be recognized as earned. As time passes, more services are delivered, the unearned revenue is earned, and the liability goes down. It has that time element that needs to be tracked (more on that later).
Since it’s a liability account, not an asset, deferred revenue has to be managed carefully. On the financial statements, it should be reported accurately to assess the company’s financial position. Also, clear reporting ensures compliance with accounting standards. Managing the unearned revenue properly contributes to better budgeting, and forecasting as well. Lastly, deferred revenue helps mitigate cash flow issues and losses in case of refunds and subscription cancellations.
For the reasons listed above, effective deferred revenue management is critical in SaaS. But it can all get a little tricky. Good management of this unearned cash on hand includes tracking, reporting, analyzing, and more. This post will demystify the nuances of those aspects and covers the best practices for managing deferred revenue.
The ABCs of Deferred Revenue
Imagine you offer a yearly plan for your subscription-based streaming service. A customer pays $1200 upfront to secure the services for the next 12 months. On day 1, you have $1200 in your account. It can pad the company’s cash flow, and keep operations running.
But accounting cannot consider it “earned”. At least not until you have delivered the streaming content to the customer over a given period. That unearned revenue is deferred revenue. When a month passes, you can move $100 from the $1200 prepayment to your recognized (or earned) revenue column. And so on until the end of the year, when the obligation has been fulfilled and all of $1200 earned.
The remaining balance after each period sticks on the balance sheet as a safety net. That’s how deferred revenue creates obligations while adding to the cash flow for effective operations. So deferred revenue has its pros and cons. It’s a double-edged sword because the company has to render the services or risk cancellations and refunds (which will also hurt customer trust).
Deferred revenue isn’t just about the company’s financial health, it also relates to customer service. For optimum financial health, operational efficiency, and customer satisfaction, the deferred revenue metric is critical.
Tracking Deferred Revenue
Deferred revenue needs to be tracked carefully and meticulously. That attention to detail ensures the unearned revenue is reflected correctly in the financial statements, and not overstated. You can pick from any number of tracking methods. But regardless of your preferred method, there are some best practices you can adopt to record and track it effectively.
Automate the Task
Depending on the size of your operation, the deferred revenue can even be tracked via spreadsheets. Manual tracking involves creating columns for unearned revenue collected from different categories — subscription revenue, product sales revenue, and more. The columns record how much of the revenue is outstanding and the dates it’ll be recognized (or earned). Once deferred revenue is earned, the columns are adjusted to recognize it.
While it is possible to track the metric manually, it’s prone to errors and takes a lot of time, especially if there are many types of deferred revenue involved. The better solution is automation. Features in accounting apps and third-party solutions can effectively handle renewals, subscription payments, and deferred revenue. These systems are efficient and time-saving. And they’re also less prone to errors and are more customizable.
Investing in automatic tracking systems can cost more upfront than low-cost or no-cost spreadsheet tracking. But in the long term, they can save money and time with reduced errors and better flexibility.
Make it a Habit
Once you have a system in place, the next step is to be as consistent as possible. Consistency helps keep your records up to date, allows you to make reliable forecasts, and avoid discrepancies in the books.
Treat deferred revenue tracking the same as other crucial business metrics and establish a schedule for it. It varies depending on the size of your business, but whatever frequency you pick — daily, weekly, or monthly — be sure to make it a habit.
Double-check the Numbers
Automated systems are far less likely to make errors in calculations, but it’s worthwhile to double-check their work every now and then. The deferred revenue the system recorded should line up with the actual payments received from customers. It keeps the records exact, saving you from future headaches.
Keep the Records Tidy
Since time is a key element in recording deferred revenue, make sure the books list the correct dates. Keep detailed and neat records of timestamped payments and timelines for service delivery. Tidy records provide a glance at the big picture — helpful not just for tracking but also for audits and forecasting.
Follow the Rules
Generally Accepted Accounting Principles (GAAP) outline deferred revenue under the ‘unearned revenue’ category. GAAP provides a set of standards for how unearned revenue should be recognized to keep financial accounting consistent and transparent. It’s important to adhere to those standards, ensuring your deferred revenue is well aligned with the recommended best practices.
Reporting Deferred Revenue
After you’ve established a routine to keep tabs on deferred revenue, the next step is reporting it effectively. Effective reporting provides a clear view of the company’s financial health. Plus, it allows you to comply with Generally Accepted Accounting Principles (GAAP) or Internet Financial Reporting Standards (IFRS) for better transparency.
Where to Report Deferred Revenue?
Deferred revenue is recorded in the financial statements, the balance sheet in particular. The balance sheet is a snapshot of the company’s financial standing. As previously noted, deferred revenue goes under the liability category on the balance sheet. It represents what the company owes the customers.
The recognized and remaining deferred revenue should be reported in the financial statements. The recognized revenue goes on the income statement, while the deferred revenue is displayed on the balance sheet.
It is also recommended to enforce clear guidelines for revenue recognition, keeping detailed, time-sensitive records, and even consulting financial pros to steer clear of audit troubles in the future.
Recognizing Deferred Revenue
As the company provides the owed services, the deferred revenue gradually turns into real revenue and the amount of deferred revenue goes down. On the balance sheet, the liability goes down, and earned revenue goes up. It’s eventually reduced to zero by the time the customer’s subscription ends. In financial lingo, it’s called revenue recognition.
It’s done periodically, as outlined in your revenue recognition policy. Typically, the revenue is recognized incrementally every month, dividing the annual subscription into 12 portions.
Cash Flow and Deferred Revenue
Deferred revenue relates to cash flow since its cash you have received from the customers. It can contribute towards operational costs. As such, it should be reflected in the cash flow statement right away.
Despite a high deferred revenue and positive cash flow, the timing difference matters. Only a fraction of the high deferred revenue is translated into real revenue over a given time frame. Therefore, a company can be cash flow positive and still net a loss. Accurate, time-sensitive reporting of the deferred revenue is vital to manage cash flow for a SaaS business.
Analyzing Deferred Revenue
Charting the timeline of service delivery as laid out in the contract, crunching the numbers for each month (or whatever period stipulated), and regularly monitoring the deferred revenue account gives you a springboard for a deep-dive analysis of the account. Meticulous analysis can help you make forecasts, and observe trends as they appear.
Look for Trends
The first thing you want to look for is the trends. It’s the foundation of forecasting and discovering insights, including trends in deferred revenue. There’s a link between sales and deferred revenue. And it can also act as a metric for customer retention and satisfaction.
For instance, if your balance is growing over time, it suggests that your sales are outpacing your ability to deliver services, adding to your delivery obligations.
Steady growth in deferred revenue month-over-month, quarter-over-quarter, or year-on-year mirrors robust sales.
If you compare your deferred revenue with Monthly Recurring Revenue (MRR) and the deferred revenue is growing faster, it could suggest that you’re securing a lot more long-term contracts. MRR and other Key Performance Indicators (KPIs) like it predict revenue recognition in the future.
Seasonal trends may also impact deferred revenue, fairly predictably. It can help with better cash management and planning for capacity.
Over longer stretches, if your deferred revenue has steadily decreased, it may suggest that your customers are securing your services for shorter periods.
Monitor the Churn Rate with Deferred Revenue
Another metric worth deep analysis is the churn rate (or the percentage of customers who quit their subscription). It has a direct impact on deferred revenue — as customers churn, you cannot provide them the services due. The company may have to refund the prepaid amount, lowering the deferred revenue.
A high churn rate, paired with high deferred revenue implies that sales are quickly replacing the lost customers with new ones.
If the churn rate is low but the corresponding deferred revenue is also low, it indicates a stable, loyal customer base. But it also means that sales are stagnating and not enough customers are coming on board to propel considerable growth.
Based on what the numbers tell you, you can get a more nuanced understanding of your company’s financial and operational condition. You can also make decisions to facilitate a better balance between customer acquisition and retention.
Customer Concentration and Deferred Revenue
Customer concentration — or the percentage of total revenue received from a select group of customers — means the deferred revenue is concentrated among customers. And if most of it comes from a few select customers, it exposes you to more risk. If one or more of those select few customers churn or delay payments, it can have a significant effect on your cash flow and bottom line.
For better stability and predictability, you should aim for a lower customer concentration. It points to more diversified revenue sources and mitigates potential risks.
Conclusion
Deferred revenue plays a role beyond basic revenue recognition. It can be pivotal in cash flow management, forecasting future revenue, and even monitoring customer retention and satisfaction.
You can use the cash flow from deferred revenue to fund and grow operations. But it has to be carefully managed and analyzed so that the services can be delivered and revenue recognized promptly.
It is also a key metric for predicting future revenue. The rate of recognition and current deferred revenue can provide valuable insights into future revenue streams. Those insights can inform budget and strategic decisions down the road.
Deferred revenue can even be a tool that gives you an edge over the competition, provided it’s accurately tracked, reported, and analyzed. Deferred revenue and its analysis can host a wealth of information about the company’s future and its financial and operational health. If managed well, it can attract investors and other stakeholders, boosting your company’s reputation.
At the same time, managing deferred revenue can seem daunting. But it doesn’t have to be. By understanding the nuances, maintaining neat, updated records, and embracing the best practices, you can master deferred revenue management. When done right, it can steer your SaaS business toward profitability and sustainability.