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January 22, 2021
Deferred revenue—also known as unearned revenue—is a vital accounting concept that helps SaaS businesses gain an accurate picture of their income.
There are many important reasons for SaaS startups to implement deferred revenue, including reporting requirements of the board and investors, the ability to properly gauge the financial performance of your business, and the ability to accurately calculate specific SaaS metrics like gross margin or monthly recurring revenue (MRR).
If you’re unsure how to calculate SaaS deferred revenue or how it fits into your accounting practices, read on to learn how to model deferred revenue for your SaaS startup.
When a customer pays upfront for goods or services that you haven’t yet provided, this payment is classified as deferred revenue.
Using the accrual accounting method, once you provide the customer with the contracted service, only then do you earn the revenue and can recognize it on your P&L or income statement. Until that point, deferred revenue is recorded as a current liability on your balance sheet: If a customer downgrades their plan or prematurely terminates a contract, you may be obligated to return any portion of the original payment that is still in your deferred revenue account.
Deferred revenue is particularly important to SaaS companies managing software subscription revenue. Traditional business models that sell and distribute tangible goods can usually recognize revenue at the time of the transaction. However, because many SaaS businesses receive upfront payments and deliver ongoing services for the duration of a contract, they must record the value of the subscription as deferred revenue liability and only recognize it in proportion to the portion of the service they have provided up to that time.
Categorizing deferred revenue as earned revenue too soon overstates a businesses sales revenue, and contributes to the inaccuracy of other important SaaS business metrics, such as gross margin, customer lifetime value (CLV), CAC payback period, or monthly recurring revenue (MRR).
For a comprehensive introduction to revenue recognition, take a look at our blog post: How To Manage SaaS Revenue Recognition For Your Startup.
The exact calculation for deferred revenue may depend on your business model, but the basic calculation for deferred revenue is:
For example, a SaaS business might bill a customer $1,200 to cover an annual subscription to its platform or service. This business can’t immediately recognize all $1,200 of the invoice because it hasn’t provided the full year’s service, so this money is considered deferred revenue. At the end of the first month, the business will have provided 1/12 of the total service, so can recognize 1/12 of the total revenue ($100). The amount of deferred revenue at the end of the first month is calculated as follows:
The process of revenue recognition continues throughout the contract, with the deferred revenue balance decreasing as the amount of recognized revenue increases. At the end of the contract, when all obligations have been fulfilled, all the revenue will be recognized and none of it will be deferred.
Three key financial statements—the balance sheet, profit and loss statement (P&L), and cash flow statement—reflect the health of the business and form the basis of financial modelling, so it’s important to understand how SaaS deferred revenue impacts these financial reports.
Working with an experienced accounting team is the only reliable way to manage revenue recognition for your SaaS business in an accurate and compliant manner. At Zeni’s team of finance experts have worked, we’ve been working with software companies for years, so we understand what it takes to set up SaaS company finances to run smoothly—including proper revenue recognition, how to record deferred revenue in subscription accounting, and maintaining compliance to standards like ASC 606/IFRS 15 (issued jointly by the Financial Accounting Standings Board (FASB) and International Accounting Standards Board (IASB) in 2014).
Zeni is a full-service finance firm that can handle all your company’s bookkeeping, accounting, and CFO functions with a combination of AI-powered efficiency and human expertise. Our team takes the hassle of maintaining your accounting system off your hands and tracks all your revenue using generally accepted accounting principle (GAAP)-compliant methods that are built to scale.