As a startup owner, there's nothing like watching those dollar signs increase in your revenue columns. It's a sign you're on the right track and building something that will last.
Although subscription businesses generate residual revenue, you’ll likely need to classify most of this as unearned. Unearned revenue is a liability, and if you leave it unchecked, you could face cash flow difficulties.
By understanding what unearned revenue is and how to account for it, you alleviate the risk of potential difficulties and manage your soaring expectations when the dollar signs go up.
Continue reading to learn what unearned revenue is and why startups should monitor it.
What Is Unearned Revenue?
Revenue falls into two categories: earned and unearned.
Earned revenue is revenue you’ve earned by providing your product or service.
Unearned revenue, also known as deferred revenue, refers to funds you collect in advance for products or services you intend to provide later.
Although unearned revenue may increase cash flow, it creates a liability because you’ve generated money for work you haven’t yet provided to the customer. If you can’t offer the remaining product or service, you may have to refund the customer.
Types of Unearned Revenue
There are several types of unearned revenue. Two of the most common for SaaS startups include annual subscriptions and contract services. Let’s dig deeper into each of these below.
Annual subscriptions are one of the most common types of unearned revenue. Let’s say you sell a SaaS website development and hosting service. You charge $2400 per year for this service, and your customers respond enthusiastically with subscriptions.
These subscriptions are unearned revenue. So you will only realize $200 in revenue per month from each..
So, in month 1, you have $200 in unearned revenue. In month 2, you have $400, and so on. The revenue only becomes realized when you provide a full year's worth of web development and hosting services.
Unearned service revenue is money you collect in advance for future services.
If you provide a software contract service, you'll likely request advanced payments for your services. However, the revenue generated will be considered unearned until you render the agreed-upon services to your client.
The Liability Of Deferred Revenue
If you generate unearned revenue, it’s important to consider the liability. You may have to pay sometion of this if you can’t complete services or the customer cancels.
If you operate under any type of contract or subscription, you should have a plan for potential service cancellations and write terms into contracts in advance.
For example, in the case of an early cancel requisition, you can prorate a refund according to the time they've used the service. This will keep your customers happy and avoid costly credit card disputes.
Investors know there’s a low likelihood that companies will convert 100% of their unearned revenue to earned revenue. That’s why collection probabilities exist. Your collection probability is the percentage of unearned revenue that typically becomes earned revenue.
By understanding your collection probability, you can provide investors and board members with financial data that isn’t misleading. You can easily show this by recording unearned revenue as a liability on your balance sheet.
How To Manage And Track Unearned Revenue
Here’s how it works:
- Revenue Generation – You generate revenue as soon as you make a sale. The portion of the revenue generated from what your customer receives immediately is counted as earned. You’ll list the remainder on the books as unearned revenue.
- Revenue Recognition – You realize revenue as you deliver products and services. For example, if you sell a $2400 annual subscription to provide monthly access to an online investing tool, you’ll recognize $200 in monthly revenue on your income statement.
The key here is to hold all prepaid revenue aside until your company actually earns it.
Why Startups Should Monitor Unearned Revenue
There are multiple reasons to keep track of your startup's unearned revenue. The two most important include:
- To Stay In the Green – As a startup, you may consider spending revenue as you generate it. After all, more revenue means more marketing opportunities and a higher income. However, if you start spending what you haven’t yet earned, you may find yourself in a tough financial position. You could spend the money needed to provide services or be unable to refund the unearned portion of revenue when a customer cancels.
- Working Capital – Occasionally, you may need access to additional working capital. You’ll likely look to lenders or the investing community. However, these parties will want a detailed understanding of your revenue (both earned and unearned) before they give you the capital you need.
Use the Right Software To Manage Your Financial Statements
You could deal with significant cash flow issues if you don't track your revenue, but staying on top of revenue can be difficult without the right tools.
The good news is that accounting technology has come a long way in recent years. When you choose a quality accounting software solution, your software will keep track of your revenue for you.
So, it’s time to ditch the archaic manual accounting processes and opt for modern accounting software solutions with tools to help you manage your revenue and earnings.