Depending on the accounting method your company chooses (or is forced to use by tax authorities), two words that you will come across regularly are “incurred” and “earned”. Let’s take a look at incurred revenue, earned revenue, and all the related accounting principles.
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Incurred vs. Earned
The first two terms we need to understand are incurred and earned:
- Incurred: The term incurred is a particularly important concept in the generally accepted accounting principles (GAAP) when using accrual accounting. This concept states that all transactions must be recognized when they are incurred regardless of when they were paid for.
- Earned: The term earned is also used in the accrual accounting system. It is the concept that revenue is recorded when it is earned, regardless of when the payment is received. This can occur before or after your customer pays their bill. Revenue is defined as earned based on the “revenue recognition principle”.
The matching principle and the revenue recognition principle are the two main guiding theories underlying accrual accounting. They are defined in GAAP and should be used by any entity following the accrual accounting system.
- Matching principle: This principle states that accountants should record all revenue and expenses in the same reporting period. This means that expenses should be matched to the revenue they generate and therefore be shifted into the period in which the revenue was earned instead of being recorded in the period they were paid for.
In general, expenses are incurred in the same period that their matched revenue is earned with a few small exceptions that are discussed later on.
- Revenue recognition principle: This principle guides how and when a company realizes its income. A company should recognize revenue in the period in which it was earned, and not necessarily when the cash was received.
This can be complicated for a subscription revenue model, especially when the payment frequency of a client doesn’t match the length of their service contract.
For example, this can mean breaking up the money received from an annual subscription payment into the monthly periods as the services are provided. Doing so provides auditors with a so-called “apples-to-apples comparison” of a company’s financial picture that is more transparent across industries.
Accrual Accounting vs. Cash Accounting
There are two main types of accounting. The first, accrual accounting, is mentioned above, while the second is cash accounting. Let’s take a look at them before we move on.
1. Accrual Accounting Method
In the accrual accounting method, revenue is recorded when it is earned. This will usually happen before money changes hands, for example when a service is delivered to a customer with the reasonable expectation that money will be paid in the future.
Expenses are similarly recognized when they are incurred. This is done by following the matching principle. Accrual accounting entries require the use of accounts receivable and accounts payable journals, as well as a few others for deferred expenses and revenue, depreciation, etc.
2. Cash Accounting
In the cash accounting method, revenues and expenses are recognized when cash is transferred. This is the system used by individuals when budgeting household expenses as well as by some small businesses.
Depending on your company size, revenue model, and physical location, you may be barred from using the cash accounting method. The matching concept or revenue recognition concept is not used in the cash accounting method, and therefore earned and incurred are not considered either.
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Examples of Incurred and Earned in SaaS Accounting
As stated above, according to many tax authorities, SaaS companies must use the accrual accounting system, which stipulates that you record earned revenue only following the revenue recognition principle.
In the case of a subscription revenue stream, this means when you have fulfilled your part of the service agreement. The following two subscription revenue examples will make this point clear.
Your company offers a discount to clients that pay their bill annually instead of monthly. You have five clients that take advantage of the discount. These invoices total $120,000. Since you must provide services to these clients for an entire year and assuming your income statements are drafted monthly, GAAP standards stipulate that you should move $10,000 at the end of each month into your revenue account and keep the remaining unearned subscription revenue in a deferred revenue account as you have not yet earned the money.
Your company bills clients at the end of the month for the services you’ve provided during the month. Most of your clients pay within the allowed time period, but some—due to issues with the payment system, the invoice hitting the spam folder, among many other reasons—do not pay on time.
In this case, even though you are earning $10,000 at the end of each month, you may not be receiving all of it until some days, weeks, or months later—or, unfortunately, sometimes not at all. In this case, you still recognize the earned revenue of $10,000 each month using an accounts receivable journal entry and then later move the revenue to your cash account when you receive the payments.
In the first case, you have more cash on hand than your company has actually earned. In the second case, you have less cash on hand than you have earned, and you might not even receive all the money you have earned. This shows the importance of keeping track of your incurred expenses and earned revenue on the one hand and your cash position and cash flows on the other hand.
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Similarly, expenses must be recognized when they are incurred regardless of when the invoice is paid. This is done by matching the expenses to the revenue they generate where possible.
When this is not easily possible, then either the “systemic and rational allocation method” or the “immediate allocation method” can be used.
The former allocates expenses over the useful life of the product, while the latter recognizes the entire expense when purchased.
Let’s consider a few examples for when expenses should be recognized.
- You decide to advertise your new SaaS product on Reddit. You set a budget of $3000 to hit your targeted market over a two-month period and pay the invoice. Assuming you draft monthly income statements, you divide the $3000 into two monthly expenses of $1500 and recognize them over the two consecutive monthly periods.
- You spend $20,000 on new laptops. It is expected that these items will last two years and have no residual value thereafter. Instead of recognizing the entire $20,000 in the first year, you should list the assets on your balance sheet and use a depreciation expense to claim $10,000 per year on your income statement.
- You spend $2000 to host a party to launch your new SaaS product. Since this party cannot be matched to any individual sale, it can be recognized under the immediate allocation method as an expense in the period it was paid.
Conclusion: The Conservatism Concept
It can be difficult for accountants to know with certainty which revenue and expenses will be earned or incurred in a period. Founders and executives can be optimistic about their company. That means that they might be overly confident about future revenue projections coming to fruition while underestimating their future expenses.
Unfortunately, accountants can fall into this trap. Fortunately, accountants are very good at understanding such risks and have developed specific guidelines to counteract these natural biases.
Thus, these principles state that increases in reported net income required stronger support than do increases in expenses. This is the “conservatism concept”. It states firms can only recognize revenue when it is “reasonably certain”, whereas they can recognize expenses when they are simply “reasonably possible”.
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