SaaS: the value of Deferred Revenue for long-term growth
Mar 10, 2022
Deferred revenue is a vital financial topic for most SaaS - even if it might not be the most exciting one. SaaS with a subscription business model need to pay close attention to their deferred revenues and to when they recognize them.
Indeed, regardless of when an invoice is issued, the revenue coming in can only be recognized when the service has been rendered. In the case of an annual subscription, it means a portion of the annual fee can only be recognized at the end of every month.
For SaaS companies, which tend to have recurring revenue, high volume of sales and a complex product mix, it can be difficult to know how much to recognize and when.
Proper revenue recognition is essential not only to remain compliant with financial standards, but it can also help foster long-term growth for SaaS scale-ups.
So, how to recognize revenue in a scalable way? How can deferred revenue contribute to your long-term SaaS growth? What tools can you use to recognize deferred revenue easily?
Read on to find out!
At Upflow, we believe tools aren't useful if they don't connect to one another. Learn more about how to have the best finance stack for your business in our dedicated webinar.
Deferred Revenue for SaaS Explained.
What is Deferred Revenue for SaaS?
According to the GAAP (Generally Accepted Accounting Principles), revenue for a sale can only be officially recognized when the service has been rendered, or a product sold. This rule follows the principles of accrual accounting, as opposed to cash-basis accounting.
For SaaS who use a subscription-based model, it means that the revenue they earn on a one-year subscription paid upfront can only be recognized month by month. The rest of the revenue is deferred revenue: revenue that hasn’t yet been earned.
Are Deferred Revenue and Unearned Revenue The Same?
Yes! Both deferred revenue and unearned revenue are terms used interchangeably.
Unearned revenue is the opposite of unbilled revenue (or accrued revenue), which is revenue that has been earned but has not been invoiced yet to your client.
How is Deferred Revenue Calculated?
In accrual accounting, unearned revenue cannot be recognized until a critical event has occurred, like a product being sold or a service performed, and a quantifiable amount of money has been exchanged.
Under the GAAP, revenue recognition needs to meet these 2 criteria:
Revenue must be paid or promised to be paid (realized or realizable),
Revenue must be earned (product or service exchanged).
Example of Deferred Revenue for SaaS.
Let’s take a short example:
A cash payment has been made on January 1st for a yearly subscription of $1.200. At this date, since the subscription service hasn’t been rendered yet, the revenue is $0, and the deferred revenue is $1.200.
At the end of each month, the company recognizes 1/12th of the deferred revenue balance, which is $100. Its compiled revenue increases by $100 each month, as the unearned revenue decreases.
It goes on until December 31st, where the deferred revenue balance is $0, and the revenue is $1.200. That is how you calculate deferred revenue.
How to Record Deferred Revenue In Your Accounting.
Deferred revenue impacts your 3 financial statements:
Cash Flow Statement: the cash is accounted for as it is received.
Profit & Loss Statement (or income statement): the revenue is recognized over time, depending on the billing cycle.
Balance sheet: while the revenue is unearned, it is accounted for as a liability in your balance sheet, as it is still technically “owed” to your customers. See the picture below for example:
Imagine that you receive $100 for a subscription - a service not yet rendered. On your balance sheet, both your cash (asset) and unearned revenue (liability) will be increased by $100.
Whenever the service has been performed (like at the end of the month), your income will be recognized on your balance sheet by decreasing the liability account and increasing the asset one.
Why Is Deferred Revenue Important For SaaS Businesses?
As most SaaS have a subscription-based business, deferred revenue is a part of their financial reality. Here is why it’s important to calculate your deferred revenue:
Deferred Revenue Is a Legal Obligation.
Chances are, you use accrual accounting for your SaaS business - like many CFOs of growing companies do. That means you can recognize your revenue only when it is earned. With a subscription business model, it can be tricky to know when that is.
The FASB and IASB both have issued accounting standards to make revenue recognition for SaaS easier - namely the ASC 606 and IFRS15. These standards follow the same 5-step rules for a revenue to be recognized.
To be compliant, you need to follow them for your accounting. It’s in itself a strong motivation for SaaS to use deferred revenue in their accounting.
Revenue Recognition Means Better Cash Flow Management.
Knowing when exactly to recognize your SaaS deferred revenue means you will be able to know how and when you can use the cash on your bank account.
It’s also helpful to compute your ARR and MRR - you can use your monthly deferred revenue being recognized as a starting point.
Tracking your unearned revenue means tracking your liquidity and your expected monthly revenue - important metrics to give to your board and investors.
Need help tracking your key A/R metrics? Have a look at our free spreadsheet!
Understanding Deferred Revenue Equals More Accurate Financial Reporting:
Tracking your unearned and earned revenues contributes to getting a more accurate picture of your revenues. Put simply, if your subscription fee is $1.000/mo, recording a $12.000 transaction at the beginning of the subscription period will not be accurate.
Once more, it’s better to have a clear idea of your revenue recognition to have an accurate MRR. Paired with your Customer Lifetime Value (CLV) and your Customer Acquisition Cost (CAC), it’ll give you good insights into your business performance.
Forecasting Is Made Easier With Deferred Revenue:
By knowing exactly when your deferred revenue from your clients will be recognized, you get a clear picture of your revenue in the future. Deferred revenue analysis is a smart move to plan ahead.
For instance, if you have 30 new clients at the beginning of the year, you know that you will be able to recognize (and use) a portion of their yearly subscription every month. Concretely, it means being able to time your cash flow better.
That’s helpful to know when (and if) you can invest, or hire new people.
The Best Stack to Defer Revenue and Grow Your Business
Before we get into software recommendations for deferred revenue for saas business, there is a central question to address: how to model deferred revenue in a scalable way?
Deferred revenue in saas, as we’ve seen, has many advantages. However, since SaaS have a high volume of sales and tend to offer a complex product mix (subscription based on usage, set up fee or training, discounts, etc.) it doesn’t exactly make it easy to calculate. At least, manually.
While saas deferred revenue accounting can be done using spreadsheets, it usually takes a lot of time and is fastidious. Chasing the right data by switching between different sheets or software makes it error-prone.
The alternative? Using software with dedicated features to compute your deferred revenue in saas business.
A few different tools can help you compute your deferred revenue - and tell you exactly when to recognize it:
Billing Tools With Deferred Revenue
Billing tools can do more than managing invoices: some also offer features that make your revenue recognition easier. That’s handy because as your invoices get paid, you know exactly how much revenue to recognize and when. No risk of overspending money you haven’t earned yet!
Concretely, the software uses your operations as a database and automatically calculates your recognized revenue balance. You then get reports telling you how much can be recognized each month.
The precise application of this depends on which software you use for your billings.
Stripe for instance offers a Revenue Recognition feature that’s embedded in their saas. Since it’s all automated, it can handle downgrades, upgrades, refunds and prorated fees on its own.
You can access your revenue recognition balance through a specific dashboard, which facilitates your end-of-month accounting and book closing. All of this is based directly on your operations, so it helps streamline all your accrual accounting.
Chargebee’s “RevRec” feature offers a similar help. Through their platform, you can issue a revenue recognition report that’s actualized every 24H, as well as a deferred revenue report. Having this kind of metrics at your fingertips is ideal for a startup or a scale-up SaaS business.
RevRec identifies the performance obligations of each contract and recognizes revenue automatically when it is paid. You can even integrate Chargebee with your CRM and accounting software to follow your revenue “from lead to ledger”.
Which Accounting Tool to Choose For Deferred Revenue?
Having an accounting tool for your startup / scaleup with a revenue recognition feature will streamline your financial reporting obligations. Indeed, it will make closing your books at the end of the period much easier and faster - and more accurate, too. It’s also helpful in case of an audit.
As you have all your accounting data in one place, it’s the ideal place to do this part of your accounting too. You can rest easy knowing the data used is congruent throughout your accounting.
With an accounting software that offers a revenue recognition feature, you can have access to your recognized revenue balance easily and plan accordingly. Different software offer different revenue recognition features:
With NetSuite for example, you can issue different rules of revenue recognition for different products/services and link them to specific items in your business contracts.
NetSuite Revenue Management automatically recognizes revenue based on a defined schedule or trigger event - in accordance with IFRS-15, ASC606 and other accounting standards.
Revenue recognition can be questioned by auditors, and having the most up-to-date data available means your audit won’t be delayed because of inconsistencies.
It’s worth noting that QuickBooks and Xero don’t offer revenue recognition, but you can still connect them with 3rd-party software to streamline the whole process.
SaaSOptics for instance automatically recognizes invoices created in Quickbooks and Xero and establishes a schedule for revenue recognition for each of the items listed.
You can set up how each of your products is recognized and decide if you want the process fully or semi-automated. It then pushes back the deferred revenue balance back into your general ledger software.
If your current accounting software doesn’t offer a revenue recognition feature and you don’t want to switch just yet, this can be an appropriate solution for the time-being.
Regardless of the tool(s) you use to help you with your deferred revenue, we recommend you use a tool that integrates with your existing finance tech stack, as it will help foster your growth.
At Upflow, we strongly believe that an open ecosystem of finance tools makes your life easier - now and in the future.
That’s why our Accounts Receivables automation software integrates with your already-existing tools, like your billing tool, accounting tool or CRM.
Even though the concept of deferred revenue is pretty straightforward (only recognize revenue when it is earned), in application, it can get complex for subscription-based businesses.
Understanding how unearned revenues work and when to recognize them is key: it’s a legal obligation to be compliant with standards such as the ASC 606. It's also a source of financial insights.
Knowing when to recognize your deferred revenue means better reporting and forecasting, as it helps you time your cash flow better.