What is deferred revenue? How SaaS teams manage this liability

Accurate financial reporting is the backbone of any successful business. For companies with subscription models, understanding deferred revenue is vital. It's about knowing not just when cash comes in, but when it's truly earned. 

This guide provides a clear and practical look at deferred revenue and how it impacts your financial health.

Read on to learn:

• What deferred revenue is, and why it's a liability
• How deferred revenue works with subscriptions
• The difference between short-term and long-term deferred revenue
• How to calculate deferred revenue
• Common mistakes to avoid
• Tools that can help you track and automate deferred revenue

Let’s kick things off by explaining what deferred revenue means. 

What is deferred revenue?

Deferred revenue is a payment a company receives in advance for goods or services it has yet to deliver. This is often seen in situations where customers prepay for subscriptions, service contracts, or other agreements. 

It's crucial to understand that even though the company has the cash, it hasn't actually earned it yet. That's why, under accrual accounting principles, particularly GAAP, this prepayment is recorded as a liability on the balance sheet. 

Revenue recognition only occurs when the goods or services are delivered. So, until that obligation is fulfilled, the money remains in the deferred revenue account.

Is deferred revenue the same as unearned revenue?

Yes, deferred revenue and unearned revenue are the same thing. They are used interchangeably in accounting. Both terms refer to the advance payments a company receives for products or services that will be provided in the future. 

The terms underscore that the revenue is not yet earned and represents a liability until the company fulfills its obligation to the customer.

Note: Check out our detailed post on SaaS revenue recognition.

How deferred revenue works in the SaaS industry and subscription models

Customers often pay upfront for subscriptions, whether monthly or annually. When a customer pays for an annual subscription, for example, the company receives a large sum of cash immediately. 

However, under accrual accounting, the revenue is recognized gradually over the subscription period. The distinction between when cash comes in and when revenue is recognized is key.  

For example, a customer paying $1,200 for a year-long subscription results in a $1,200 increase in cash. However, only a portion of that, $100, is recognized as revenue each month. 

The remaining $1,100 is deferred revenue, a liability. As each month passes, $100 shifts from deferred revenue to recognized revenue. This way, the company's financial statements accurately reflect the services delivered.  

How does deferred revenue affect cash flow?

Deferred revenue has a notable impact on cash flow. Initially, it boosts a company's cash position. When a user pre-pays, the company gets cash upfront, improving liquidity. However, it's important to remember that this cash inflow doesn't translate to immediate revenue.  

From a cash flow perspective, the initial payment increases cash from operating activities. Then, as the company recognizes revenue each month, the deferred revenue liability decreases. This decrease offsets the recognized revenue, resulting in a neutral impact on cash from operating activities in subsequent periods. 

Takeaway: While deferred revenue provides an initial cash influx, its effect on overall cash flow is spread out over the subscription period, aligning with service delivery.

Is deferred revenue an asset or a liability?

Deferred revenue is classified as a liability, not an asset. The company has received payment but has not yet fulfilled its obligation to deliver the promised goods or services. Therefore, the company owes the customer the product or service, or a refund if it fails to deliver. It represents a financial obligation, which is the definition of a liability.  

The conversion of deferred revenue to recognized revenue happens gradually. As the company delivers the goods or provides the services, a portion of the deferred revenue is recognized as earned revenue. 

For example, with a year-long subscription, each month, a fraction of the total payment is moved from the deferred revenue liability account to the revenue account on the income statement. 

This process continues until the entire obligation is fulfilled, and all the deferred revenue is recognized as earned revenue.  

Note: Understanding deferred revenue is vital for effective FinOps. Proper management of these liabilities allows for more accurate forecasting and resource allocation, key components of financial operations. Want to learn more? Check out our post on the best FinOps tools.

Short-term vs. long-term deferred revenue

Deferred revenue can be categorized as either short-term or long-term, depending on the period over which the goods or services are delivered. The distinction is essential for accurate financial reporting. Here’s a definition of each:

• Short-term deferred revenue: It refers to obligations expected to be fulfilled within one year. Short-term deferred revenue is classified as a current liability on the balance sheet.  
  
  A common deferred revenue example here is a monthly or annual software subscription. The company owes the customer service for the duration of the subscription, typically less than a year.

• Long-term deferred revenue: It involves obligations extending beyond one year. Long-term deferred revenue is classified as a non-current liability on the balance sheet.  An example can be a multi-year service contract or a long-term maintenance agreement.

When reporting these on financial statements, companies must separate the two. Short-term deferred revenue appears within current liabilities, while long-term deferred revenue falls under non-current liabilities. This separation gives stakeholders a clearer picture of the company's financial obligations and their timelines.

How to calculate deferred revenue

Calculating deferred revenue is straightforward. The basic formula is simple:

Total Cash Received for Future Services − Revenue Recognized = Deferred Revenue

This calculation applies when a company receives upfront payments for services or goods it has yet to deliver. For example, in a deferred revenue example where a customer pays $1,200 for an annual subscription, and one month's service has been provided, the calculation would be:

$1,200 (Total Cash) − $100 (Revenue Recognized) = $1,100 (Deferred Revenue)

This ties directly into accrual accounting. Under this method, revenue is recognized when earned, not when cash is received. Therefore, the portion of the cash payment that represents future services remains as deferred revenue, a liability, until those services are rendered.

Note: Want to learn more about how expenses impact your financial statements? Check out our guide on the operating expenses formula.

Journal entries: Is deferred revenue a debit or credit?

When a company receives payment in advance, it records a journal entry to reflect the increase in cash and the corresponding liability. It's here that deferred revenue typically appears as a credit. Here's an example:

A company receives $10,000 for a service to be provided in the future. The journal entry would be:

• Debit: Cash $10,000
• Credit: Deferred Revenue $10,000

Deferred revenue is credited because it represents a liability. The company owes the customer the service or product. As the company fulfills its obligation over time, it gradually transitions deferred revenue into earned (or recognized) revenue.

To transition from deferred to earned revenue, the company reduces the liability and recognizes income. For example, as it delivers the service, the journal entry would be:

• Debit: Deferred revenue (reducing the liability)
  
• Credit: Revenue (recognizing the earned income)

For example, if the company recognizes $1,000 of the $10,000 as earned revenue, the journal entry would be:

• Debit: Deferred Revenue $1,000
• Credit: Revenue $1,000

This process continues until all the deferred revenue is recognized, and the liability is reduced to zero. Understanding these journal entries is crucial for accurate financial reporting.

Examples of deferred revenue across industries

Deferred revenue is a common occurrence across various sectors, arising whenever a company receives payment before fulfilling its service or product delivery. It's a foundational concept in accrual accounting. Here's how it manifests in different industries:

Why deferred revenue matters for financial reporting

Deferred revenue plays a critical role in accurate financial reporting, especially for SaaS businesses. GAAP compliance is a primary reason. Accounting standards require companies to recognize revenue when earned, not when cash is received. Deferred revenue confirms businesses adhere to this principle, presenting a clear and accurate financial statement.  

Beyond compliance, deferred revenue significantly impacts revenue forecasting. By tracking these liabilities, companies can better predict future revenue streams. A steady increase in deferred revenue often signals strong future earnings.

Investor reporting is another crucial aspect. Investors rely on financial statements to make informed decisions. Deferred revenue provides clarity into a company's obligations and future earnings. It lets investors assess the company's long-term financial position accurately.

Common mistakes in deferred revenue accounting

Accurate handling of deferred revenue is essential for financial clarity. However, several common mistakes can cloud the picture. Here are some pitfalls to avoid:

• Recognizing revenue too early: A frequent error is to recognize revenue before the service or product is delivered. It inflates current earnings and misrepresents financial health. Companies must adhere to accrual accounting principles, recognizing revenue only when earned.
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• Failing to differentiate short-term and long-term deferred revenue: Mixing short-term and long-term deferred revenue can distort the balance sheet. It's crucial to classify them separately. 
  
  Short-term liabilities are due within a year, while long-term liabilities extend beyond that. Proper segregation provides a clearer view of financial obligations.  

• Incorrectly reversing the liability: Timing is critical when transitioning deferred revenue to earned revenue. Reversing the liability too quickly or too slowly leads to inaccuracies. It must align with the actual delivery of goods or services.  
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• Overlooking contractual obligations: Neglecting the specific terms of customer contracts can cause issues. Detailed contracts dictate when and how revenue is recognized. Ignoring these details leads to incorrect accounting.  
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• Lack of proper documentation: Insufficient documentation makes it difficult to track and verify deferred revenue. Accurate records are vital for audits and financial analysis. Companies must maintain clear, detailed records of all transactions.

Tools to help track and automate deferred revenue

Accurate tracking of deferred revenue is vital, and thankfully, various tools make this process easier. Automation is key to avoiding errors and saving time.  

ERP systems play a significant role. They offer integrated solutions for financial management, including the ability to track deferred revenue. These systems provide a centralized platform, ensuring data accuracy and consistency.  

Billing platforms are another vital tool, particularly for SaaS businesses. They automate the billing process, which, in turn, simplifies deferred revenue tracking. 

An automated billing platform can help to accurately track and reverse deferred revenue. They handle recurring payments, automated invoicing, and provide real-time data, making it easier to manage subscriptions and recognize revenue correctly.  

Spreadsheets vs. automation

Spreadsheets might seem like a simple solution, but they are prone to errors and require manual updates. Automation, on the other hand, reduces the risk of human error and frees up finance teams to focus on strategic tasks.

Make deferred revenue work for your SaaS business

We've thoroughly explored the intricacies of deferred revenue and its significant impact on your SaaS accounting. Now, it's time to introduce a solution that transforms your billing operations: Orb.

Orb is a done-for-you billing management platform designed for SaaS firms. We handle the complexities of revenue recognition and empower your finance team. Here's how Orb empowers your accounting team to master deferred revenue:

• ASC 606 compliance: Orb simplifies revenue recognition, helping you align with ASC 606 standards. We reduce manual intervention, helping you confirm that your deferred revenue is accounted for correctly.
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• Accurate revenue reporting: With Orb, you gain precise insights into your revenue. Our platform provides the data you need for accurate reporting on recognized, unbilled, and, crucially, deferred revenue.
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• Adaptable pricing: Orb supports a wide range of pricing models, from usage-based to subscription and hybrid. This agility allows you to experiment with pricing models that impact deferred revenue recognition without being constrained by rigid systems.
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• Granular usage data: Orb unlocks your usage data, giving you the visibility needed for accurate billing and deferred revenue calculations. We help you understand how usage patterns translate to revenue recognition schedules.
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• Accounting integration: Connect Orb with your accounting software to automate data flow and eliminate errors. We accelerate your month-end close process, helping you make sure deferred revenue is reported accurately.

Ready to start using Orb for your SaaS company’s billing? Check our flexible pricing options and find a plan that works for you.