Is Deferred Revenue a Liability? - Baremetrics

Yes. Yes, it is. But, if you want to know why, you might need to read a bit more of this article — this article will dive into what are liabilities, what is deferred revenue, and how you need to document these values in your accounting. 

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What is a liability?

Simply put, a liability is something that your company owes. This can be anything from a 30-year mortgage on an office building to the bills you must pay in the next 30 days. If you want a refresher on all the basic accounting jargon, we have you covered. We will definitely be using some of those terms here. 

Now, you might be wondering: If a liability is something you owe, then how can revenue be a liability? To understand this, you need to appreciate what is meant by deferred.

What is deferred revenue?

For a SaaS business founder, it is crucial to understand how deferred revenue works because dealing with subscription revenue is a crucial part of  SaaS accounting. If you go to a store and buy a computer with cash, everything happens simultaneously for you and the shopkeeper. In one instance, the shopkeeper receives the cash owed and has earned the revenue. Likewise, you lose the cash and receive your laptop.

However, with a SaaS subscription model, you often earn revenue you haven’t received yet or receive revenue you haven’t earned yet. 

If you have earned revenue but haven’t received it, you have revenue sitting in an accounts receivable journal. If you have received revenue you haven’t earned yet, then you have generated deferred revenue.

But why is deferred revenue a liability, you may ask? 

The simple explanation is that you owe your client services, as they have paid you for services you have not yet rendered. A liability is something you owe, and even if you owe services, it is still something owed.

This isn’t a bad thing, but it does require some caution. 

Deferred revenue has some interesting characteristics. Let’s look at some of them.

1. Deferred revenue should be treated differently from other cash.

Since you haven’t provided the services yet—services for which you may incur expenses—you should treat the cash received as deferred revenue more carefully than other revenue. Although it looks the same sitting in your bank account, you should be careful not to rely on revenue that you have not yet earned. At best, this is leveraging your future profitability, while at worst you could be spending money that might end up needing to be returned if a customer cancels their subscription early. 

2. Deferred revenue is good debt.

Assuming that you can keep your customers happy enough not to cancel early and that you have the skills and capacity to deliver your services, then deferred revenue is an interest-free loan from your customers. 

3. Deferred revenue impacts your financial statements differently.

Because you have cash coming in that is not yet earned, deferred revenue will show up on your statement of cash flows but not your income statement. It also shows up as a liability on your balance sheet. This pinpoints one of the many ways your financial statements show different and complementary information. You need them all to appreciate your company’s financial health truly, and we will look at how all this works in detail below.

Deferred revenue in cash accounting and accrual accounting

There are two main accounting systems: cash accounting and accrual accounting. Which one you use will depend on the size of your company, its ownership profile, and any local regulatory requirements. 

In cash accounting, revenue and expenses are recognized when they are received and paid, respectively. That means there is no deferred revenue. Once you are paid, the revenue goes on your income statement. 

In accrual accounting, things are a lot more complicated. Revenue is recorded when it is earned and not when the cash is received. If you have earned revenue but a client has not yet paid their bill, then you report your earned revenue in the accounts receivable journal, which is an asset. Conversely, if you have received revenue from a client but not yet earned it, then you record the unearned revenue in the deferred revenue journal, which is a liability.

Deferred revenue financial statements

Deferred revenue affects the income statement, balance sheet, and statement of cash flows differently. 

Deferred revenue shows up in two places on the balance sheet. First, since you have received cash from your clients, it appears as part of the cash and cash equivalents, which is an asset. However, since you have not yet earned the revenue, deferred revenue is shown as a liability to indicate that you still owe the client your services.

Since most prepaid contracts are less than one year long, deferred revenue is generally a current liability. However, if you are in the enviable position of having clients paying for multiple years of service upfront, then part of your deferred revenue will be considered a long-term liability. 

Deferred revenue does not appear on the income statement. However, in each accounting period, you will transfer part of the deferred revenue account into the revenue account as you fulfill your part of the contract. Then, the recognized revenue will appear on the income statement.

The statement of cash flows simply shows what money flows into or out of the company. Since deferred revenue is cash received, it shows as a positive number in the operating activities part of the cash flow statement. It doesn’t matter that you have not earned the revenue, only that the cash has entered your company. 

Deferred revenue example

Let’s look at how deferred revenue journal entries work. Consider the following three simple scenarios. For simplicity, in all scenarios, you charge a subscription fee of $500 per month for clients to use your SaaS product.

• Scenario 1: On January 31st, your client pays you $500 for services rendered during the month of January.

• Scenario 2: Your client fails to pay you on January 31st for the services rendered during January and instead pays you on February 28th. 

• Scenario 3: Your client pays you $6000 on January 1st to use your service over the following year.

Scenario 1

This is the simplest case. You receive cash at the same moment that you earn the revenue. Since they overlap perfectly, you can debit the cash journal and credit the revenue journal.

Scenario 2

In this scenario, you need to use two sets of journal entries. On January 31st, you earn the revenue but do not receive the cash, so you credit the revenue account the same as in Scenario 1. Instead of cash, you debit accounts receivable to show that you are still waiting on the cash. Then, on February 28th, when you receive the cash, you credit accounts receivable to decrease its value while debiting the cash account to show that you have received the cash.

Scenario 3

In this scenario, you have received cash before you have earned the associated revenue. On January 1st, to recognize the increase in your cash position, you debit your cash account $6000 while crediting your deferred revenue account to show that you owe your client the services. Then, at the end of each month, you will reduce the deferred revenue liability by crediting it $500 while debiting the revenue account on your income statement to show that you have now earned a portion of the deferred revenue.

Use Baremetrics to monitor your subscription revenue

Whether you have earned revenue but not received the cash or have cash coming in that you have not yet earned, use Baremetrics to monitor your sales data.

Baremetrics makes it easy to collect and visualize all of your sales data so that you always know how much cash you have on hand, which clients have paid, and who you still owe services to. When you have many clients, some are subscribed on an annual basis while others monthly, with multiple tiers and various add-ons, it can be difficult to calculate your MRR (Monthly Recurring Revenue), ARR (Annual Recurring Revenue), LTV (Customer Lifetime Value), and so much more. Thankfully, there is Baremetrics to do all of this for you.

Baremetrics can even monitor your SaaS quick ratio so you know immediately if your accounts receivables are getting out of control. It can even help make sure you collect on delinquent accounts. Integrating this innovative tool can make financial analysis seamless for your SaaS company, and you can start a free trial today.