Deferred revenue, also known as unearned revenue, is an accounting concept that measures advance payments a company receives for products or services yet to be delivered or performed over future periods. It forms one of the vital concepts in ensuring accuracy in matching incomes with the corresponding time periods in which the related goods or services are delivered within the accrual accounting principles.
Nature of Deferred Revenue
GAAP also tells when your revenues should be classified under the “earned” umbrella and when to classify them under the “deferred” umbrella. A business earns revenues only when it meets its obligations toward its customers. Unless such an obligation is met, the money a company receives cannot be considered its revenues. Then what should be classified as received money? This is where the term deferred revenue comes into play.
What is Deferred Revenue in SaaS?
To access SaaS subscription-based business’ services, customers must make upfront payments. Think of a Spotify subscription. For example, to enjoy any of Spotify’s monthly subscription plans, customers have to pay a certain upfront fee. That fee is then collected and put into the company’s account. However, the company cannot yet add this income to its revenue. This is because the company has not yet provided its steaming services to the customer. With the failure of the firm to provide its steaming services to the customer, the accrued income will, therefore, be treated as deferred revenue.
Over some periods, the SaaS company’s deferred revenue gets converted into earned revenue as the SaaS company completes its promised provision of services. The SaaS industries are increasingly transforming into subscription-based, hence seeing an increase in their deferred revenue. This, too, defers revenue and has its advantages along with it.
With regard to the positives, deferred revenue is the sure future income of a company. It provides the organization with the finances that it needs to optimize operations in advance. Paying in advance reassures the customers that they are also receiving the services.
Deferred Revenue vs. Accrued Revenue vs. Unearned Revenue
Both of them, deferred and accrued revenue, represent revenue recognition principles. Both of these concepts help you recognize your revenue at the right time.
Deferred revenue is the payment you’ve collected in advance but have yet to provide the service. On the other hand, accrued revenue is the amount of income you have earned but have not received yet. It is a concept that is contrary to deferred revenue. Accrued revenue is the money the company will eventually collect because it has gone about its duty toward the customer. That is, it has ‘earned’ the revenue and just needs to be collected.
Deferred Revenue Management
Effective management of deferred revenue requires robust accounting systems and practices that can monitor both the timing and nature of the obligations in revenues and their realization. This becomes high if considered in some industries such as software as a service, telecommunications, and subscription-based services, where advanced payments are usually the rule of thumb.
Challenges with Deferred Revenue
There are several challenges associated with deferred revenue:
- Estimation and Allocation: Revenue assignment to appropriate periods proves challenging, especially in multi-element arrangements, where payments cover several different goods or services.
- Customer Satisfaction: Companies must ensure they meet their customer obligations to convert their deferrals to recognized revenues. Non-compliance will lead to the necessity of revenue adjustments and reputational loss.
- Regulatory Changes: Accounting standards might change how firms recognize deferred revenue, which would require adjustments to accounting policies and practices.
Strategic Implications
The stability of a more predictable revenue stream means that strategic financial planning also becomes more stable. Companies often regard deferred revenue as a significant indicator of business health and potential growth within sectors using subscriptions or long-term contracts.
In conclusion, this concept of deferred revenue is one of the pivotal ideas in accounting that impacts financial statements, compliance, business operations, and strategic planning. This can be expressed as deferred revenue, which refers to the amount of money a SaaS company receives for which it has yet to earn. Accumulated payments fall into the category of deferred revenue as long as the company still has obligations it needs to fulfil for the customers. Once the obligation is fulfilled, then and only then is the revenue considered earned revenue. Deferred revenue can thus be considered a liability on a company’s financial statements as much as it represents pending obligations. It needs to be tracked efficiently so that financial transparency is kept intact.
