What is Deferred Revenue and How Does it work?

Favored by Software as a Service (SaaS) businesses, deferred revenue is an effective business model, but distinct from regular revenue. You’ll also want the right technology to track and recognize your revenue effectively to make this model work.  

What is Deferred Revenue?

We’re all familiar with the idea of ‘getting now and paying later’. Deferred revenue is simply the reversal of this concept. You’re probably paying several bills, or for services, using advanced payment already. Here are some examples.

• A yearly subscription to your favorite magazine uses a deferred revenue system because they haven’t supplied you with a year’s worth of content upon your purchase.
• A SaaS company uses subscription-based deferred revenue when they sell a license for their new application. They’re supplying customers with technology services for a defined period of time with an upfront fee. 

What’s key to remember is that this revenue hinges on the successful delivery of the items/services to the customer.

How Do You Account for Deferred Revenue?

Deferred revenue is unlike regular revenue in that the payment is made to you before a transaction is complete. Let’s look at this step-by-step example.  

1. A software company charges a customer for a yearly subscription of your software. This means the customer payment represents 12 months’ worth of deferred revenue. *Note that this is not income yet.*
2. After each month the company supplies the customer with the product, the deferred revenue will decrease by a month’s amount and be converted to actual revenue after each month.
3. This goes on for the entire lifecycle of the subscription, culminating in the total conversion of deferred revenue to actual revenue. 

With this model, you haven’t earned revenue until the goods or services are fully delivered. Because you haven’t delivered on your obligations, the customer still has a technical right to the monies received. It’s for this reason that deferred revenue is considered a liability on your balance sheet. And why it must be carefully monitored.

What Are the Risks of Deferred Revenue?

As with any business model or industry, there’s naturally some risk involved. However, this doesn’t make deferred revenue riskier to manage than regular revenue. The major hurdle for deferred revenue is that there must be a complete delivery of the product and/or service dictated by revenue recognition principles governed by your local country and industry GAAP.

In a subscription, the company must provide the item, according to pre-set terms, for a set period of time to the customer. Essentially, the business owes the client the product for this time. While the company has been given the fee in advance, the company now has to earn it in full. If you don’t successfully provide the deliverables, or the deliverables don’t satisfy the client-subscription terms, the company is at risk of losing that income altogether, along with the customer. 

Recurring issues in fulfilling delivery could generate an unfavorable reputation for your business too. This also lowers your appeal to investors. Ineffective revenue planning and management can jeopardize growth opportunities as well. To scale effectively with this revenue method you need to be able to successfully plan around delivery and mitigate any barriers to success. It’s important that you have an effective accounting tool to effectively monitor and recognize revenue.

Smooth, Easy Revenue Management with Accounting Seed

Accounting Seed is a double-entry GAAP and IFRS-compliant system. Our rapid revenue recording feature lets you easily recognize revenue according to your unique requirements. Customize your accounts receivable for revenue recognition based on your own procedures and policies for a smoother and more efficient process. You can also automate your revenue recognition via the Application Programming Interface (API) to further streamline workflow.

Drill-down to account details to visualize customer behavior, work efficiency, and other data. This is critical both for maintaining financial accuracy and identifying the best strategies to save money and achieve a return on investment. Our intuitive reporting features help you identify major risks and opportunities to maximize the benefits of the deferred revenue model.