Deferred revenue is cash that you’ve already collected, but revenue that hasn’t been recognized yet.
Revenue Recognition is an accounting principle where revenue is reported as it’s earned. Revenue can only be earned when the company has provided the service that’s been paid for.
Deferred revenue is a liability. The money has been received, the cash is in your bank account, but the services or goods being paid for have not yet been delivered. This means that at any time, the customer could ask for their money back. If you’ve already spent it, you’d be in a fair bit of trouble. By accounting for revenue before the service has been provided, you’re not accurately representing your company’s financial health.
This is why you must understand that cash does not equal revenue.
This is a big difference between typical SaaS metrics and proper accounting standards. Accrual based accounting, and Generally Accepted Accounting Principles (GAAP) mandate that revenue should only be accrued when a revenue recognition event occurs. A revenue recognition event is the exchange of a service – for example, providing a month worth of cloud storage.
There’s usually a cost associated with a revenue recognition event. By using accrual based accounting, and only recognizing revenue when the service is delivered, you’re able to match up revenue with expense for the service.
Deferred revenue is typically accounted for monthly, although in reality, each second that ticks by with you providing the service realizes another second’s worth of revenue.
Accounting for Deferred Revenue
Let’s take a look at a hypothetical annual contract to show what it would look like on the books.
On May 1st, you’ve signed up a new customer on a $24,000 annual contract. They pay the full amount upfront. This means you’ve got $24,000 cash in your bank account. However – you can’t include it in your revenue reports yet.
Instead, we recognize $2000 of revenue each month as the service is provided. On May 1st, we debit the bank account with $24,000 and credit liabilities (specifically the deferred revenue account) with $24,000.
On June 1st, we debit our deferred revenue account by $2000, and credit our revenue by $2000 as the month of service was provided. Here’s what that looks like in chart format:
Accounting for Additional Services
Say you also include a one time set-up fee in a contract. Is this revenue recognized as soon as you set up the customer’s account?
Unfortunately not. It’s also realized in a straight line along with the monthly fee. Why? Because it doesn’t have standalone value as a separate accounting unit. Since this set up fee is required for every customer using your service (and can’t be purchased separately) it must be realized along with the remaining value in the contract.
This changes if a customer purchases a one time add-on later in the contract that does have standalone value – say a professional service contract for additional work. You’d then recognize the revenue from the new service over the delivery timeframe.
Talk to an expert
It definitely becomes more complicated the more plans, pricing options and services you offer. We highly recommend working with an accounting firm to ensure you’re following GAAP and accurately representing your current financial health. Otherwise, you might have an issue if you go to raise funding, get a loan or just miscalculate your available funds.