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Is Unearned Revenue a Liability and How to Record It?

by
in
Maciej Wilczyński
Managing Partner, Founder Valueships
January 29, 2024
revenue
SaaS

SaaS company's financial reporting often resembles a complex puzzle, where each piece must fit precisely. Among these pieces, unearned revenue plays a crucial role, often sparking questions about its nature and impact on a company's financial health.

What is Unearned Revenue

Unearned revenue, also known as deferred revenue, represents funds received for goods or services yet to be delivered. It's a prepayment from clients for future services, which the company has an obligation to fulfill.

Let's say, for example, a company receives $1,000 in advance for services to be performed over the next 10 months. Initially, the entire $1,000 is recorded as unearned revenue. Each month, as services are performed, $100 would be transferred from unearned revenue to earned revenue.

Examples of Unearned Revenue in SaaS

Annual Subscriptions

Annual subscriptions are a classic example of unearned revenue. When a customer pays upfront for a year-long service, the company recognizes this as unearned revenue, gradually converting it to earned revenue over the subscription period.

Advance Rent Payments

Some SaaS companies may also receive advance rent payments for the use of their platforms or services. These payments, recorded initially as unearned revenue, reflect the company's obligation to provide uninterrupted service in the future.

Prepaid Service Agreements

Prepaid service agreements, where clients pay in advance for a specified period of service, are another form of unearned revenue. These agreements ensure cash flow stability but require accurate financial reporting to reflect the deferred service obligation.

Custom Development Projects

For custom development projects within a SaaS framework, clients often make advance payments. These payments, considered unearned revenue, are recognized as revenue only when the specific service tasks are completed.

Extended Licensing Deals

Extended licensing deals, involving upfront payments for long-term software use, also contribute to unearned revenue. The revenue from these deals is recognized over the license period, aligning with revenue recognition principles.

Is Unearned Revenue a Liability?

Yes, unearned revenue is a liability. In accounting, unearned revenue refers to funds received for goods or services yet to be delivered. It's recorded on a company's balance sheet as a liability, not as revenue on the income statement.

This is because the receipt of these funds creates an obligation for the company to deliver services in the future. Under accrual accounting principles, revenue is recognized only when the service is performed or the product is delivered.

Therefore, until the company fulfills its obligations, unearned revenue remains a liability. This approach ensures that a company's financial statements accurately reflect its current obligations and future income, crucial for accurate financial analysis and reporting.

Why is Unearned Revenue Important for SaaS?

Unearned revenue holds a pivotal role in the financial landscape of SaaS companies. Let's explore why it's so crucial, through seven key aspects, each illuminated with examples.

1. Cash Flow Management

Unearned revenue, often seen as a liability, is actually a boon for cash flow. When a client pays in advance, this cash influx boosts the cash account, providing the necessary capital for immediate expenses. For instance, if a SaaS company receives advance payment for an annual subscription, it can use this cash for development costs or marketing efforts. This advance payment ensures a steady cash flow, crucial for maintaining operations and planning future expansions.

2. Revenue Recognition Accuracy

Accrual accounting principles mandate that revenue is recognized when earned, not when received. Unearned revenue accounts help SaaS companies adhere to these principles. For example, when a company receives payment for a service not yet rendered, this amount enters the unearned revenue account. Over time, as the company fulfills its service obligations, it gradually transfers this amount to the earned revenue account, ensuring accurate revenue recognition in each accounting period.

3. Improved Financial Reporting

Unearned revenue contributes to more accurate financial statements. It's recorded on the balance sheet as a current liability, reflecting the company's obligation to deliver future services. This recording enhances the clarity of the company's financial position. For instance, deferred revenue from prepaid subscriptions appears on the balance sheet, providing stakeholders a clear view of the company's future revenue commitments and financial health.

4. Compliance with Financial Standards

Recording unearned revenue correctly is vital for compliance with Financial Accounting Standards Board (FASB) regulations and the Securities and Exchange Commission (SEC) guidelines. This compliance is crucial for SaaS companies, especially those publicly traded or seeking investment. Properly accounting for deferred revenue ensures that a company's financial reporting aligns with legal and industry standards, mitigating the risk of legal complications.

5. Risk Management and Planning

Unearned revenue aids in risk management and financial planning. By recognizing revenue only when it's earned, companies can avoid overstating their financial performance. This cautious approach is essential for long-term financial stability. For example, if a SaaS company relies on advance rent payments, recognizing this as unearned revenue ensures that the company doesn't prematurely count it as profit, thus maintaining a realistic view of its financial standing.

6. Customer Commitment and Trust

When a customer makes an advance payment, it signifies trust in the SaaS company. Recording this as unearned revenue reflects the company's commitment to deliver value in the future. This practice fosters customer trust and loyalty. For instance, when a client pays for a prepaid service, they expect the company to fulfill its service promise. Accurately accounting for this as unearned revenue demonstrates the company's dedication to meeting its obligations.

7. Insight into Business Health

Unearned revenue provides valuable insights into a company's health and future performance. A consistent increase in unearned revenue might indicate growing customer trust and market demand. Conversely, a decline could signal potential issues in customer satisfaction or market position. For example, a steady rise in deferred income from software licenses can suggest a growing customer base and stable future revenue, crucial for strategic planning and investment decisions.

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How to Predict Deferred Revenue?

Analyzing Historical Data Trends

To predict deferred revenue, start by examining historical data trends. Look at past periods to identify patterns in how and when your customers typically pay for goods or services. This analysis can reveal seasonal fluctuations or growth trends in deferred revenue, providing a basis for future predictions.

Understanding Customer Payment Behaviors

Gaining insights into customer payment behaviors is crucial. Analyze the payment terms and cycles of your clients, especially for long-term contracts like annual subscriptions. This understanding helps in predicting when and how much revenue will be deferred in future periods.

Monitoring Sales and New Contracts

Keep a close eye on new sales and contracts. An increase in sales or the signing of significant new contracts can lead to a corresponding increase in deferred revenue. Tracking these developments allows for more accurate forecasting of future deferred revenue.

Implementing Forecasting Models

Utilize forecasting models that incorporate variables such as historical deferred revenue, current sales trends, and contract lengths. These models can provide a more systematic and data-driven approach to predicting deferred revenue.

Key Takeaways on Unearned Revenue Liability

  1. Historical Analysis: Reviewing past deferred revenue trends is key for accurate forecasting.
  2. Customer Payment Insights: Understanding how customers pay and their contractual terms aids in predicting deferred revenue.
  3. Sales Tracking: Monitoring ongoing sales and new contracts is crucial for forecasting future deferred revenue.
  4. Forecasting Models: Implementing sophisticated forecasting models can enhance the accuracy of predictions.
  5. Balance Sheet Review: Regularly examine the balance sheet for changes in the deferred revenue account.
  6. Income Statement Correlation: Understand how recognized revenue on the income statement correlates with changes in deferred revenue.
  7. Compliance with Accounting Principles: Ensure that predictions align with accrual accounting and revenue recognition principles.
  8. Regular Updates: Continuously update predictions based on new sales data, contract changes, and economic factors to recognize revenue.

Conclusion

Understanding the intricacies of revenue recognition, from earned to unearned revenue, is crucial for any SaaS company. Valueships.com can be a big help in this field and a pivotal resource in optimizing pricing strategies

By aligning pricing with the nuances of a company's balance sheet, cash flow statement, and revenue recognition principles, we at Valueships, help ensure that financial statements accurately reflect the company's performance. Our expertise in accounting reporting principles and understanding of accrued revenue, prepaid revenue, and other metrics can guide SaaS companies in making informed decisions. Ultimately, we can enhance our clients’ ability to manage liabilities and assets effectively for long-term success.

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FAQ on Unearned Revenue

Is unearned revenue a liability quizlet?

Yes, unearned revenue is a liability. It represents funds received for goods or services not yet delivered, creating an obligation for the company. This liability is recorded on the balance sheet until the company performs the services or delivers the goods.

Is revenue an asset or liabilities?

Revenue is neither an asset nor a liability; it's an income statement item reflecting the earnings a company generates from providing goods or services. When revenue is earned, it contributes to a company's profitability but does not directly affect the balance sheet's assets or liabilities.

Why can unearned revenue be classified properly as a current liability?

Unearned revenue is classified as a current liability because it represents an obligation to deliver goods or services within a short period, typically within one accounting year. It's money received in advance for services or products to be provided later.

Is unearned revenue a contra asset?

No, unearned revenue is not a contra asset; it's a liability. Contra assets reduce the value of related assets, whereas unearned revenue represents an obligation to provide future services or deliver goods, recorded as a liability on the balance sheet.

What is an income statement?

An income statement is a financial statement that shows a company's revenues and expenses over a specific period. It provides insight into the company's profitability by detailing earned revenue, costs, and net income or loss for that period.

How to improve unearned revenue account?

To improve the unearned revenue account, focus on increasing advance sales and prepayments for goods or services. This can be achieved by offering incentives for early payments, creating attractive prepayment plans, and ensuring reliable delivery of goods or services to maintain customer trust.

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Maciej Wilczyński
Managing Partner, Founder Valueships

Expert in B2B pricing, monetization and value-based selling strategies. Over the past year, he has completed over 40 consulting projects in Europe. Prior to founding Valueships, he worked at McKinsey & Company, mainly in the TelCo, software, and banking industries. He completed his doctorate in pricing in SaaS start-ups at the University of Economics in Wrocław, where he also lectures.

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Maciej Wilczyński
Managing Partner, Founder Valueships

Expert in B2B pricing, monetization and value-based selling strategies. Over the past year, he has completed over 40 consulting projects in Europe. Prior to founding Valueships, he worked at McKinsey & Company, mainly in the TelCo, software, and banking industries. He completed his doctorate in pricing in SaaS start-ups at the University of Economics in Wrocław, where he also lectures.