Sure, balancing income and expenses on your financial reports is pretty straightforward. But it becomes a whole different ball game once deferred income is involved.
Deferred income can be complex due to the subscription-based model of SaaS businesses. Think of the routine pricing changes, upfront payments, and one-time fees. Couple them up with discounts and you have a headache.
Despite its nuances and complicated nature, deferred revenue is popular with growing and big SaaS businesses. In fact, the IRS requires any business consistently making $27 million and above in gross revenue to use deferred income.
If you’re looking to better understand deferred income and how it works, stick around. This post has got you covered.
TL;DR
- Deferred income represents payments made to your company in advance for products and services to be delivered in the future.
- It’s treated as a liability on the company’s balance sheet. The company is obligated to deliver the products or services paid for by the customer through the end of the subscription period.
- It helps SaaS companies in financial planning since it gives you an insight into your future financial performance.
Understanding Deferred Income for SaaS Businesses
Deferred income is unearned revenue. It’s payments from customers for your products or services in advance.
This is highly relevant if you’re a SaaS company, because your business model is subscription-based. Customers pay for services monthly, quarterly, biannually, or annually. According to the Generally Accepted Accounting Principles (GAAP), earned revenue is only recognized once services are rendered, not once payment is made.
As such, payment made for undelivered services becomes deferred revenue- it’s unrecognized.
Deferred income is more like a two-way street; it has both benefits and drawbacks. Its most prominent benefit is financial planning since it gives you an insight into your future. According to a 2016 study, a company’s deferred revenue is a valid indicator of its future financial performance.
If your deferred income for the coming months is steady, it’s safe to say your business is growing. On the other hand, a dwindling deferred revenue means that your customers aren’t renewing their subscriptions, which might signal a looming cash flow crisis.
Looking at your deferred revenue numbers will help you analyze your customer churn rate, tweak your business strategy, and plan your startup capital accordingly.
What Are the Types of Deferred Income?
It’s important to distinguish the difference between accrual and deferral revenue. While they’re both popular methods of accounting, their differences lie in timing.
Accrual revenue is when goods and services have already been delivered but you’re yet to receive payment (accounts receivable). An example of accrual revenue is when a service provider delivers their services before receiving payment.
On the other hand, deferred revenue is when a company receives a payment in advance for a product or service to be delivered in the future (pre-paid and deferred revenue account).
Much like deferred revenue, deferred expenses involve the transfer of money for obligations to be met in the future. They’re expenses that have not yet been incurred. For example, rent payments made in advance are deferred expenses.
There’s also the concept of deferred compensation, which is when you opt to delay payment for goods and services to a later date. The most common forms of deferred compensation are retirement and pension plans where employees defer part of their payments to be paid once they retire.
How Deferred Income Works
Deferred income is considered a liability on the company’s balance sheet. The company is obligated to deliver the products or services paid for by the customer through the end of the subscription period.
In other words, you’re indebted to the customer until you deliver. The GAAP states that companies must practice accounting conservatism and only recognize revenue once certain tasks have been completed.
Deferred income is also treated as a liability since the customer may cancel their subscription or your company is unable to deliver the products or services. In such a case, your company will have to refund the customer, unless the contract states otherwise.
As for the taxes, SaaS companies can use deferred revenue to offset their tax burden. Income is taxable once it’s recognized. Your accountant can use your company’s deferred revenue, take a net operating loss, and postpone the taxes to a later date. This leaves your company with cash to reinvest.
Keep in mind that this strategy allows you to ‘delay’ the tax bill, not completely avoid it.
Example of deferred revenue
The formula used to calculate deferred revenue may vary depending on the business model. But the most basic formula is:
Invoices Value − Earned Income = Deferred Revenue
For instance, let’s say your SaaS business charges a $100 sign-up fee and a $100 monthly subscription fee. In March, a new customer pays $1,100 ($100 for the sign-up and $1,000 as an advance payment for every month up to December.)
At the end of March, $100 will become earned revenue. Your accountant will note $900 as deferred income on the balance sheet. Every month, $100 moves from unearned revenue to recognized income.
On December 31st, the deferred revenue balance will be $0 and the earned revenue will be $1,100.
Recognition of deferred revenue on SaaS financial statements
Deferred revenue has a direct impact on three statements that are crucial for financial reporting. They are:
- Cash Flow Statement– This statement records cash, not revenue. As such, it doesn’t necessarily distinguish the difference between unearned or recognized income. Any prepayment amount is recorded as received.
- Balance Sheet– The balance sheet is used to show the amount your company owns and owes at any particular time. The balance sheet has two sides- credit and debit. Cash received is recorded under debit (left side) while deferred revenue liability is recorded under credit (right side.)
- Profit and Loss (P&L) Statement– Also known as an Income Statement, this report shows your revenue and expenses over a certain period. However, the P&L statement doesn’t reflect deferred income. The earned revenue reflects over time, based on the billing cycle.
Benefits of Deferred Income for SaaS Businesses
Recording and tracking your deferred revenue can help your business in a few ways, including:
Cash flow management
SaaS deferred revenue helps you time your cash flows accurately and make better decisions on how to spend the money. You can then plan to plow more capital back into the business, such as hiring more professionals.
For example, let’s assume an ideal situation where all your customers make upfront annual subscription payments. You have 5,000 customers, each paying $600 annually ($50 per month). Assuming you have a 10% churn rate, here’s how you can forecast your annual revenue:
4,500 customers (after 10% churn) ⨉ $600 annual subscription = $2,700,000
While the recognized revenue for January will be around $225,000, you can spend up to $2,700,000 should you need to.
Keep in mind that this calculation doesn’t consider any customers signing up mid-year.
On top of the monthly income, deferred revenue also helps you monitor your company’s liquidity. These metrics come in handy when reporting to the board or talking to new investors.
Revenue recognition and financial reporting
If your monthly subscription income is $500, reporting $6,000 on your financial books isn’t accurate.
Cash and revenue aren’t quite synonymous for any business that depends on monthly, quarterly, or annual subscriptions. SaaS businesses with a small number of large customers experience a surge in cash flow one month and might not receive any cash the following months.
Revenue recognition and financial reporting for an accountant working in such a business may be an uphill task if they don’t understand accrual accounting and deferred revenue.
Challenges and Considerations of Deferred Income
Granted, deferred revenue is a powerful approach for SaaS businesses to leverage. But it also poses a few risks and challenges that you need to be aware of.
Regulatory and compliance issues
As we’ve seen, the IRS requires you to use accrual accounting for your financial reporting.
But most SaaS businesses face the issue of recognizing when revenue was earned.
To counter this issue, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) have come up with the IFRS15 and ASC 606 accounting standards.
Tax laws and regulations are also bound to frequent changes.
Complying with these laws while navigating the ever-changing scene can be quite demanding. Yet failure to stay updated and comply with these laws can lead to penalties and legal issues.
Another issue to consider is the varied laws depending on the state or country. For example, a multinational SaaS company might face some compliance issues when expanding to a new state with different tax codes and regulations.
Timing and recognition challenges
Timing and revenue recognition for SaaS companies can be complex. The accountant needs to factor in different contractual terms, performance agreements, and delivery schedules to ensure accurate financial reporting.
Imagine you run a calendar and scheduling software tool company that receives upfront payments for year-long subscriptions. If you recognize this income immediately instead of deferred revenue spread out through the year, your company might look more profitable on paper than it actually is.
This inconsistency can lead to bad business decisions based on inaccurate revenue numbers.
Impact on financial health and business operations
Proper financial planning and forecasting require accurate revenue recognition. Misreporting can lead to audit problems which have dire financial health impacts on the company.
Cash management is also harder when working with deferred revenue. For example, your business might have huge cash payments in January from annual subscriptions leading you to believe that you have more liquid assets.
This can mislead you to hire more employees or expand your business without factoring in the true cost of delivering your products and services throughout the year.
How Can SaaS Businesses Manage Deferred Income Better?
SaaS transactions have a few characteristics, such as differing contract terms, subscription-based usage, high sales volume, and discounts, that make it complex to manage deferred income.
How can you manage your deferred income better?
Best practices for businesses
Here are some crucial areas to focus on to stay on top of your deferred revenue management:
- Maintain accurate documentation– Strictly keep your records up-to-date. This includes transaction amount, date received, date expected to be recognized, contract terms, and subscription agreements.
- Regularly reconcile your deferred income– Regular assessments will help you maintain healthy cash flow and spot any inaccuracies in the accounting process. Besides, you’ll also get a better insight into your assets.
- Ensure timely delivery– Have a system in place to track when goods and services are to be delivered. This helps you recognize revenue immediately and steer clear of potential bookkeeping errors.
- Comply with accounting principles– Accounting standards provide guidelines on deferred income recognition. Ensure you’re updated and understand the specific requirements for your industry and apply them accordingly.
- Understand your business model– Different business models may have varying methods of recognizing revenue. Understand the nuances of your business model for accurate revenue recognition.
Leverage billing tools with deferred revenue
While you can use spreadsheets for your deferred revenue accounting, this would make the process slow and prone to errors. Imagine how tedious it is to chase data while switching between different sheets.
Your best bet? Using a software tool that helps you automate subscription management and billing. And this is where Stax Bill comes in.
Stax Bill offers automation solutions aimed at helping you streamline business efficiency through automated recurring billing, sealed revenue loopholes, and automated invoicing and subscription management.
The best thing is that our revenue recognition system is ASC 606 compliant, meaning you won’t have to worry about proper taxation.
On top of that, our tool gives you real-time analytics through over 40 reports to help you track your cash flow, and MRR/ARR growth to make data-based business decisions.
Conclusion
The concept of deferred income is pretty straightforward. It represents payments made to your company in advance for products and services to be delivered in the future. Revenue is only recognized once it’s earned.
While things can become a bit complicated when it comes to applications in subscription-based SaaS businesses, using deferred revenue helps you comply with legal guidelines and make accurate business forecasts.
Properly accounting for and managing deferred revenue can be a great pillar of your SaaS business’ financial strategy.
FAQs about Deferred Income
Q: What is deferred income?
Deferred income, also known as unearned revenue, refers to payments received by a company for goods or services that are yet to be delivered or performed. It is recorded as a liability on the company’s balance sheet because it represents an obligation to deliver products or services in the future.
Q: What is an example of deferred income?
An example of deferred income is when a customer pays for a one-year subscription to a software service upfront. If the customer pays $1,200 at the beginning of the year for the subscription, the company recognizes this payment as deferred income and gradually recognizes it as revenue over the 12-month period as the service is provided.
Q: How do you record deferred income?
Deferred income is recorded on the balance sheet as a liability. When the payment is initially received, it is recorded as a credit to a deferred income account (increasing liabilities) and a debit to cash or accounts receivable (increasing assets). As the goods or services are delivered over time, the deferred income is recognized as revenue, decreasing the liability and increasing revenue.
Q: What is the difference between accrued income and deferred income?
Accrued income refers to revenue that has been earned but not yet received. It represents goods or services that have been delivered but for which payment has not yet been collected, making it an asset on the balance sheet. On the other hand, deferred income is payment received for goods or services not yet delivered, recorded as a liability because it represents an obligation to the customer.
Q: Is deferred income a debt?
Technically, no. But while deferred income is not a debt in the traditional sense of a loan, it is a liability. It represents an obligation of the company to provide goods or services in the future for which it has already received payment. The company is indebted in the form of the obligation to deliver those goods or services, rather than owing money.
Q: Why would you defer income?
You need to defer in come to comply with the revenue recognition principle of accounting, which states that revenue should be recognized in the accounting period in which the goods or services are delivered, not necessarily when the payment is received. This helps in accurately reporting the company’s financial position and performance by matching revenues with the expenses incurred to generate those revenues, thus providing a more accurate picture of the company’s profitability and financial health.
