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SaaS Deferred Revenue: What It Is & How To Track It

SaaS Deferred Revenue

 

For any type of business, financials can be a complex beast.

Even more so for the SaaS business model. There are a lot of things to consider. You have your recurring revenues, your one-time fees, and your add-ons.

Now, if you’re only offering monthly plans, it’s relatively easy to record transactions in your books. You earn money each month, and your customer gets one month of access to your SaaS product.

But what about annual or multi-year plans? You receive payment on one accounting period but are yet to deliver the service over a longer period of time.

How do you account for that?

That’s where SaaS deferred revenue comes in.

In this article, we will talk about what SaaS deferred revenue is, why it’s important to track, and how to track it.

 

What Is SaaS Deferred Revenue?

 

Generally, deferred revenue is any payment that a business receives in advance for products or services that are not yet delivered.

It is also called prepaid revenue, unearned revenue, and deferred income.

In the case of SaaS, deferred revenue typically comes in the form of annual or multi-year contracts.

The customer pays upfront for a year (or more) of access to your SaaS product, but the service is delivered on a monthly basis.

This means that, at any given time, there is a portion of your subscription revenue that has been paid for but not yet earned.

This can create some challenges when it comes to SaaS accounting and cash flow, especially if you’re recording it using accrual accounting.

 

Deferred Revenue & Accrual Accounting

 

To get a better understanding of deferred revenue, let’s have an overview of accrual accounting.

In accrual accounting, revenue is recognized when it is earned, regardless of when the cash is actually received.

For example, let’s say a customer pays for a year’s worth of access to your SaaS product in December, but the service will be delivered on a monthly basis starting in January.

That means the paid subscription revenue will be gradually recognized over the course of 12 months (January to December).

This is in contrast to cash-based accounting, where revenue is only recognized when the cash is received.

For SaaS companies, accrual accounting is the more popular choice because it reflects the reality of the business more accurately.

Recurring revenue, by its very nature, is earned over time.

Under cash-based accounting, you would already recognize the entire amount as revenue once you and your customer sign the contract and you received the payment.

This can create a bit of a timing issue in the area of accounting. You still have to provide the service in later accounting periods, but the revenue is only reflected in one accounting period.

Let’s take it into perspective through our earlier example.

When it comes to your books, you would have a revenue spike in January when the contract is signed. Then it would be followed by 11 months of zero revenue.

This doesn’t give an accurate picture of your SaaS company’s financial performance.

However, with accrual accounting, you would recognize the revenue as it is earned, which means that the deferred revenue would be recognized over time as well.

In our example above, you would recognize a portion of the revenue each month over the course of 12 months, which gives a more accurate representation of your business.

This gives you a better idea of your true cash flow since it more accurately reflects when the revenue is earned.

 

Deferred Revenue & Revenue Recognition

 

A key principle under accrual accounting is revenue recognition, which is the process of identifying specific conditions under which revenue is recognized.

The main condition is that the product or service must be delivered.

In the case of SaaS, this means that the customer must have had access to your product in order for revenue to be recognized.

So, under SaaS revenue recognition, you can have two types of subscription revenue: recognized revenue and deferred revenue.

Recognized revenue is the income that has been earned and can be reported on the income statement.

Deferred revenue, as we mentioned earlier, is the revenue that has been received but not yet earned.

For example, let’s say you have a customer who pays you $12,000 upfront for a year of access to your SaaS solution.

In this case, the entire $12,000 would be considered deferred revenue at the beginning as your customer starts using your product.

Once the service is delivered on a monthly basis, each month’s worth of service would be recognized as earned revenue. So after 6 months, your recognized revenue would be $6,000, while the other $6,000 would be your deferred revenue.

And after 12 months, the entire $12,000 will be recognized as earned revenue.

 

Why Is Tracking Deferred Revenue Important?

 

There are a few key reasons why it’s important to track deferred revenue.

 

It Helps You Improve Cash Flow Management

 

As we mentioned earlier, deferred revenue gives you a better idea of your true cash flow.

This is because it more accurately reflects when the revenue is earned, rather than when the cash is received.

This is important because it allows you to make more informed decisions about your business.

For example, if you know that a portion of your revenue is deferred, you may be more conservative about how you spend that money. After all, you will still need at least some of those resources to provide the service due to the paying customer.

What’s more, tracking deferred revenue can also help you come up with more accurate revenue forecasts.

This is because you’ll have a better idea of when the revenue will be recognized and can plan accordingly.

 

It Applies The Matching Principle In Accounting

 

The matching principle is an accounting standard that states that expenses should be matched with the revenue they helped generate.

In other words, expenses should be reported in the same period as the revenue they helped generate.

For example, let’s again say you have a customer who pays you $12,000 upfront for a year of access to your software.

If you recognize the full 12 grand right away, it wouldn’t match the additional expenses for support, development, and other costs that will be incurred over the course of the year as they use the software.

However, if you track deferred revenue, you can more accurately match the expenses with the revenue by recognizing a portion of the revenue each month.

This gives you a more accurate picture of how your expenses lead to revenue.

What’s more, this accounting principle makes sure that you are compliant with accounting regulations and associations.

These include the following:

So not only is it a more accurate way of tracking your finances, but it’s also the method that’s accepted by financial institutions.

 

How To Track Your SaaS Deferred Revenue

 

Deferred revenue affects three types of financial statements:

This might sound complicated, but it’s actually pretty simple to track.

Here are some things you should do as you track your SaaS deferred revenue:

 

Create A Revenue Recognition Schedule

 

A revenue recognition schedule is simply a list of the revenue that you’re receiving over time.

This can be helpful in keeping track of deferred revenue since it shows you exactly how much of it you have and when it will be recognized.

To create a revenue recognition schedule, you’ll need to gather some information about your deal with the customer.

You will need the following information for each customer:

  • The date the contract was signed
  • The contract value
  • The length of the contract (in months)
  • The recurring monthly fee
  • The start date of the service

With this information, you can create a schedule that shows when each customer’s deferred revenue will be recognized.

For example, let’s say (again) that you have a customer who signs a 12-month contract for $12,000 on January 1st. The contract has a recurring monthly fee of $1,000.

The revenue recognition schedule would look something like this:

 

Sample revenue recognition schedule for a 12-month contract

 

As you can see, the deferred revenue is recognized each month over the course of 12 months.

This schedule can be helpful in two ways.

First, it can help you keep track of how much-deferred revenue you have at any given time.Since you can physically see it on a schedule, it can be easier to wrap your head around.

Second, it can help prepare your balance sheets ahead of time. This is because you’ll need to include the deferred revenue as a liability on your balance sheet.

If you have the schedule, you can easily see how much deferred revenue you need to account for each month.

 

Record Cash As An Asset & Deferred Revenue As A Liability

 

Throughout this article, we’ve mentioned once or twice that you need to account for deferred revenue as a liability.

Why is that?

This is based on the accrual accounting method we discussed earlier.

With this method, you would record the cash received as an asset on your balance sheet. And you would record the deferred revenue as a liability.

Cash, whether earned or not, is always an asset.

You can use it to pay your office bills, reinvest in business growth, or give bonuses to your employees. So it’s important to track it separately from deferred revenue.

Meanwhile, deferred revenue is not an asset because you are yet to provide the service that the customer has already paid for. So, it is rather a liability.

So how should cash and deferred revenue appear on your balance sheet?

Let’s take our earlier example. Imagine a customer paying you $12,000 upfront for a year-long subscription to your SaaS product, from January to December.

In January, the $12,000 cash you received would be recorded as an asset, while you also add a deferred revenue of $12,000 to your liabilities.

Then, each month as you provide the service, you would recognize $1,000 in revenue and eliminate $1,000 from the deferred revenue liability.

So by December, the $12,000 in cash would still be an asset on your balance sheet. But the deferred revenue liability would have been completely eliminated since you have already provided full service to the customer.

 

Use Accounting Tools That Can Track Deferred Revenue

 

Tracking your deferred revenue can be simple enough that you can just use a spreadsheet, right?

Not exactly.

While a spreadsheet might work for a small business with just a few customers, it’s not going to cut it as you scale up.

You need an accounting tool that can help you automate the process and make things easier as your business grows.

You may want to use tools like QuickBooks and Xero, which offer features that allow you to easily track deferred income.

With these tools, you can simply input the information about each customer’s contract, and the software will automatically generate a deferred revenue schedule.

This can save you a lot of time and effort in the long run, especially as your business grows and you have more customers to keep track of.

 

Final Thoughts About SaaS Deferred Revenue

 

SaaS deferred revenue is the portion of a customer’s payment that you have not yet earned.

It’s important to track because it gives you a better understanding of your cash flow and makes sure that you have proper revenue recognition.

You can track deferred revenue using a spreadsheet or by using accounting software like QuickBooks or Xero.

Keep in mind that deferred revenue is not an asset, but rather a liability, because you have not yet provided the service to the customer. So, it should be recorded as such on your balance sheet.

Through deferred revenue accounting, you can get a better handle on your cash flow and keep tabs on your progress towards achieving your goals.

Want more guides to help you take your SaaS business to the next level? Check out our blog here.

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Ken Moo