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.
When money comes in and services are rendered on different timelines, it can be difficult to keep track of what invoices have been collected and who is still owed services. Baremetrics can help you keep track of your growing business by providing 26 metrics about your business: MRR, ARR, LTV, total customers, etc. Let’s go through how that works below together.
The first two terms we need to understand are incurred and earned:
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.
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.
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.
Read more: Marching and Revenue Recognition Principles
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.
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.
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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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.
Example 1:
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.
Example 2:
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.
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.
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.”
Baremetrics integrates directly with payment gateways including Stripe, and visualizes your subscription and financial information crystal-clear dashboard.
Baremetrics offers metrics, dunning, engagement tools, and customer insights to help you grow your business faster. Some of the many metrics Baremetrics monitors are MRR, ARR, LTV, the total number of customers, total expenses, and Quick Ratio.
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