By Fizal Meera, Associate Controller – CFO Plans.
(Note: This article is meant for non-accounting business professionals with minimal or no accounting knowledge)
You may have heard of prepaid income or perhaps unearned income. Well, It’s all identical. They are just alternative ways of naming deferred revenue
Software subscriptions are the survival tool of any SaaS business. Still, most businesses do not correctly record this primary source of revenue, which includes subscription Revenue and also the corresponding deferred Revenue balance.
For instance, assume your client pays $12,000 for a year’s subscription and you assign the full revenue amount (or the invoice total) to a single month instead of spreading the $12,000 over twelve months, then the revenue is considered to be overstated by $11,000 for that month because the balance $11,000 belongs to deferred revenue (not revenue).
As an owner of a business that deals with SaaS, it is imperative to grasp the concept of deferred revenue. More importantly, it’s tough to manage the financial performance of your business without a proper understanding of revenue recognition and recording.
What is deferred revenue?
When you bill a business for a one-year subscription, you haven’t earned that income yet. You earn it for the duration of the subscription in the future. Therefore, you need to “park” the unearned revenue income as a liability until you earn it in the future.
Suppose you billed a customer for a one-year subscription and received the full amount in advance. However, you can not recognize this income instantly on the Income statement. You need to recognize the unearned income portion in the Balance Sheet as a deferred revenue liability. Because you owe service (an obligation) to your client.
Why is deferred income essential to implement?
There are several important reasons.
In order for revenue to be recognized, it must be “earned” and you must have delivered the service for it to be considered “earned”.
Large surges and slumps based on invoicing will muddy the management information process. Companies plan their overheads to match the revenue. If the revenue reporting is incorrect, the decisions based on it can cause severe consequences.
SaaS businesses rely heavily upon unit economics. Simply put, you should be making a positive gross bottom line on each item you sell, no matter how small or large it is. Once you figure that, it is a matter of selling more of the same units, first enough to cover overheads (break-even point), and then even more units to increase the net bottom line. Therefore, it is paramount that each month’s revenue is stated only as it is earned so planning based on that would be accurate.
Investors and Lenders
Investors and lenders will find it challenging to know how your business is performing without proper revenue recognition. Decisions related to funding, profit distributions, business strategy are all dependent upon it.
If you invoice your customers quarterly, semi-annual, or annual subscription terms, the recommendation is implementing a deferred revenue process from the beginning. There are multiple software plugins available for general ledger systems (and most ERP systems have it embedded) to handle deferred revenue properly.
CFO Plans team can certainly help implement and run it so you can also be one of the efficiently run companies under our belt and sleep easy!