When running your own SaaS, operating in ecommerce, or starting your own company in any other industry, you may encounter different revenues. Some will be accrued immediately, while others will come over time.
The second ones are called deferred revenue, and today we'll talk more about them. So, if you are unfamiliar with this term and want to know more, this article is for you.
What is Deferred Revenue?
Deferred revenue, also called unearned revenue or deferred income, is a common accounting practice that helps companies properly recognize revenue over time. It works according to the matching principle, which states that revenue should be recognized when earned, not before.
In simple words, this approach is not the same as actual revenue.
Deferred revenue liability acts like a promise of revenue until the goods or services are delivered - then, it becomes revenue.
It's a critical concept in accounting, especially for businesses with subscription-based or long-term service contracts.
How Deferred Revenue is Generated
Deferred revenues are generated when a business receives advance payments from customers for goods or services that have not yet been delivered or earned.
Here's the process in more detail:
- Advance payment - a business receives cash payment, checks, or credit cards from a customer before it has provided the products or services.
- Obligation to deliver - in exchange for these payments, the business must provide the customer with products or services later. This obligation is typically outlined in a contract or agreement between the business and the customer.
- Revenue record - instead of recognizing the entire payment as revenue immediately, the business records the payment as deferred revenue on its balance sheet. This means the payment is recorded as a liability because the company owes the customer goods or services in the future.
- Recognition over time - as the business fulfills its obligation by delivering the goods to the customer, it gradually recognizes the deferred revenue as actual revenue on its income statement. Revenue is recognized in proportion to the work completed or the goods delivered.
Does it remind you of the way subscriptions work? And aptly so!
Benefits and Challenges of Deferred Revenue
Deferred revenues have an important role and provide many benefits. However, they also present some challenges.
So, let's meet the pros and cons of this revenue.
⭐ Benefits
#1 Accurate revenue recognition
It ensures that revenue is recorded in a manner that accurately reflects the performance of the business and provides a clear picture of the company's balance sheet. It also allows recognizing revenue in accordance with the revenue recognition principle, which is a fundamental concept in accrual accounting.
#2 Steady cash flow
Recording annual subscription payments as deferred revenue can help ensure a steady cash flow over time. Instead of receiving a large sum of cash upfront and potentially facing cash flow challenges later, the company receives the revenue evenly over the subscription period.
#3 Transparency
Deferred revenue is reported as a liability on the balance sheet, which provides transparency about the company's obligations to deliver goods or services in the future.
🚫 Challenges
#1 Can make the wrong impression
Deferred revenue can result in lower sales revenue on the income statement initially. This can give the impression of poorer company performance.
#2 Can be complex
Managing deferred revenue can be complex, especially for businesses with multiple revenue streams or complex contract terms. Thus, companies must accurately track and record deferred revenue for each transaction.
#3 It's less flexible
Deferred revenue can create challenges for cash flow. Since companies haven't received the entire payment yet, they can't afford to make large investments, which they would do if they already had all the revenue. But this problem can be avoided by properly planning expenses.
Examples of Deferred Revenue in Different Industries
Deferred revenue refers to many cases and in many industries. Check out some of the examples.
#1 Software Subscription in SaaS
If a SaaS company sells an annual subscription for $120 to a customer in January, it would record the $120 as deferred revenue on its balance sheet. As each month passes and the company provides access to its software, it will recognize $10 of revenue each month, so by the end of the year, the entire $120 will have been recognized as revenue.
#2 Gift Cards in E-commerce
In the e-commerce sector, a popular example of deferred revenue arises with gift cards or vouchers. When a customer buys a $50 gift card, the e-commerce company records the $50 as deferred revenue on its balance sheet. As the customer redeems the gift card for purchases, the deferred revenue is gradually recognized as actual revenue.
#3 Customized Products in Manufacturing
In manufacturing, companies may receive advance payments for customized or made-to-order products. Suppose a machinery manufacturer collects $10,000 upfront to build a specialized machine. A customer pays $10,000, which is logged in the deferred revenue account. As the manufacturer progresses with the machine's production or delivery, portions of the deferred revenue are recognized as revenue.
#4 Magazine Subscriptions in Publishing
In the publishing industry, magazines frequently rely on deferred revenue from annual subscriptions. When a customer subscribes to a magazine for a year, the publisher records the subscription fee as deferred revenue. Each month, as the magazine is delivered to the subscriber, other parts of the deferred revenue are recognized as revenue on the income statement.
5 Best Practices for Managing Deferred Revenue
Now it's time for the best practices that will help you better manage your deferred revenue. We took into account, among other things, 5 areas:
1️⃣ Meticulously keep recording all transactions related to deferred revenue. Maintain clear documentation of contracts, subscription agreements, or sales orders that stipulate the terms and conditions. This will help in tracking the timing and amount of revenue that needs to be recognized.
2️⃣ Perform regular checks on your deferred revenue. As a result, you will identify any discrepancies or errors in the accounting process and ensure accurate financial reporting.
3️⃣ Stay updated and compliant with relevant accounting standards, which provide guidelines on revenue recognition. Understand the specific requirements for your industry and apply them correctly to your deferred revenue.
4️⃣ Establish effective communication channels between finance, sales, and customer service teams. Ensure that sales and customer service teams are aware of policies and timelines. Thanks to such collaboration, you will prevent misunderstandings and potential customer disputes.
5️⃣ Get help from specialists like Valueships. No matter if you have problems with understanding deferred revenue, you are not sure if implementing this service will be good for your business, or you simply want to get a hand with pricing strategies, our specialists will help and solve your problems. We work with many industries and have vast experience, so we are sure we can support you.
Take advantage of our strategy consulting services, and don't act blindly but on the basis of solid data and research. We will be happy to help you with this.
Understand Deferred Revenue and Run Your Business like a Pro
Deferred revenue, as one of the basic accounting concepts, allows companies to present their finances accurately. Understanding and properly managing it is necessary for any business.
If you want to enrich your strategies and make the right pricing and revenue decisions that will strengthen your company, don't hesitate to reach out to Valueships.
We are always at your service with our knowledge and experience.
