What is Deferred Revenue?
Deferred revenue continues to be where most accountants struggle the most... It can be a real pain to calculate, and an even larger pain to understand 🤕
In this article, we're gonna dive deep and learn all about it.
Let's start with the definition:
I’ve seen a lot of definitions for deferred revenue…but I like this one the most:
Deferred Revenue is the $$ amount of goods or service that you currently owe to your customers
That can arise whenever
➡️ a contract gets signed…
Or
The key thing is whenever an unconditional right to collect payment exists
Where it shows up
Since Deferred Revenue is something you owe...
It goes on your Balance Sheet as a liability.
Once you then recognize the amounts, it will flow into your Revenue section of your Profit & Loss.
How do you calculate Deferred Revenue?
It’s fairly simple: Beginning Deferred Revenue
➕ Invoices / Cash collected
➖ Revenue recognized
= Ending Deferred Revenue
To take this one step further, here are the associated journal entries:
How do you Reconcile Deferred Revenue?
When it comes to reconciling Deferred Revenue...I've generally seen 2 methods for contracts that have a defined start and end date...
With this method, you’d take the contract value, and divide it evenly over each month.
That means a $12,000 contract will get $1,000 evenly over a 12 month contract…
IF the contract starts in the middle of the month, you may amortize only 50% of your revenue in the first, and then do a catch up 50% after the last month
Alternatively, you may set up a cutoff date - ex: all bookings past the 20th of the month will start getting amortized next month
👍 What I like about this approach:
Your revenue will look pretty consistent across each month of the contract
👎 What I don’t like about this approach
Your revenue formula can get fairly complex if you use revenue cutoff date, or to apply the prorating in the first and last month
It can also be difficult to reconcile revenue with inconsistent / weird contract dates, like let’s say from March 28th - April 9th
With this method, you calculate the amount of days over the total contract, and then amortize each month’s revenue as it compares to the total amount of days
👍 What I like about this approach:
With this approach, you can use one simple formula, without having to remember about cut off dates, or applying special rules for the first and last month.
This works especially well for contracts with inconsistent dates across your data set
It’s also a fairly common approach that I see deferred revenue software's use
👎 What I don’t like about this approach:
For months like February, your revenue could look like it declined (since there are 28 days), even though nothing may have changed about the contract
Here's an example of how to reconcile the Deferred Revenue using the Daily method
Why it's important
Deferred revenue represents a legal obligation to provide goods or services to customers in the future.
Deferred revenue can be triggered when you collect advanced payment from a customer, or if you have an unconditional right to payment that is due (see ASC 606-10-45-2 below)
Deferred revenue can be a large reason for a cash to accrual differences between what was recorded as revenue (accrual), and what was collected in cash
What about contracts that don’t have a specified start and end date?
For contracts that get earned depending on usage (like a prepayment), you’d have to go with a different approach where you tie usage to the balance
An example of Deferred Revenue
Say you’re a SaaS startup…and you sell a $12,000 annual license That triggers Deferred revenue, leaving you with a balance of $12k After the first month, you would recognize 1/12 in revenue… And subtract 1/12th from your Deferred Revenue… Leaving you with a Deferred Revenue balance of $11k Like this: Beginning balance: 0
➕ new collections / invoices: $12,000
➖ revenue recognized this month: $1,000
= ending Deferred Revenue of $11k