What is deferred revenue? How SaaS teams manage this liability

Sometimes customers may pay upfront for your software before they use it, so you get the cash before you’ve actually earned it. This income is essentially deferred revenue, or money you owe customers until you deliver what they paid for.

What is deferred revenue?

Deferred revenue is a liability that records cash collected before earning it. Customers prepay for access (annual SaaS plans, support retainers, prepaid service contracts). 

The cash hits your bank today, but revenue is recognized later as you deliver the service under accrual accounting. In practice, you earn a piece each period and reduce the deferred revenue liability by that same amount.

Example: A customer prepays $1,200 for a 12-month subscription. You credit deferred revenue $1,200 on day one, then recognize $100 as revenue each month while debiting deferred revenue by $100, until the liability reaches zero.

Deferred revenue vs. Unearned revenue

They are the same concept. You’ll see both terms used interchangeably. Some sources also say “deferred income.” All three mean cash received first, service later, so it sits in liabilities until you deliver.

Note: To go deeper on the terminology, read our post called unearned revenue vs. deferred revenue.

How deferred revenue works in the SaaS industry and subscription models

SaaS teams deal with upfront cash from annual and multi-year contracts, plus monthly plans. The mechanics are consistent:

• Invoice/collect cash. Record cash (debit) and deferred revenue (credit).
  
  
• Deliver service over time. Each period, debit deferred revenue and credit revenue for the earned portion.
  
  
• Track changes. Add-ons, upgrades, and pauses change the recognition schedule.
• Disclose classification. Split current vs. long-term on the balance sheet if the obligation extends beyond 12 months.

SaaS deferred revenue rises when sales collect prepayments faster than services are delivered. That can be a healthy signal (future revenue already contracted), but remember it’s still a liability until earned.

Note: For timing rules and patterns, see our SaaS revenue recognition guide.

How does deferred revenue affect cash flow?

Cash flow from operations increases when you invoice and collect upfront. Later, as you recognize revenue, you reduce the liability, but that recognition doesn’t bring new cash. Over the contract, cash led, revenue followed. 

Managing this timing is key for forecasting, especially where sales pull forward annual prepayments. 

Is deferred revenue an asset or a liability?

Deferred revenue is classified as a liability. You owe service or a refund until delivery is complete. If the remaining performance period is ≤ 12 months, it’s a current liability; otherwise, present the excess as long-term. 

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 or ending at the one-year mark. 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

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: If you reconcile earned vs deferred monthly, our SaaS revenue reconciliation guide shows practical workflows.

Deferred revenue: Journal entry

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.
• 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.  
• 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.  
• 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.

Note: Need your finance stack lined up? See our SaaS accounting software post.

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:

• Define billable metrics without extra engineering. Orb ingests raw usage events so that you can define your own billable metrics. Use the Orb SQL Editor or a visual editor to do so without engineering. Build new pricing plans and iterate as you learn.
• Keep invoices accurate as pricing evolves. Orb RevGraph decouples usage data from pricing logic, so invoices remain accurate and up to date. Even as you evolve your pricing, invoices are recalculated in order to stay accurate.
• Model changes before you ship them. Run Orb Simulations on historical data to preview revenue and usage outcomes before launch. Orb enables forecasting so that finance and product teams make more informed decisions about pricing and packaging.
• Support seat-plus-usage and other hybrids. Seat-plus-usage pricing offers a combination of predictable and scalable revenue, provided the right systems are in place.
• Connect your go-to systems. Direct integrations are vital for making sure that your usage and revenue data is synced across all systems. Orb’s scalable API is equipped to ingest high-volume event data, keeping billing data accurate as your user base grows.

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