There’s nothing like making a sale and receiving payment. The process is simple when what’s purchased is delivered when the cash is received. The product or service is provided to the customer, you receive payment and can immediately recognize the revenue. What happens when cash is received in advance of you delivering the purchased products or services? While you may have cash in hand, you have yet to earn the revenue – this is known as deferred revenue recognition.
Deferred revenue refers to payment received for products or services that the customer will receive in the future. Since the money received is unearned, you need to record the amount received as a liability on the balance sheet. Simply put, any money received – including deposits, prepayments, and retainers – in advance of delivering the products or services must be recorded as deferred revenue.
Why Deferred Revenue Recognition is Handled as a Liability
The reason deferred revenue is considered a liability can be summed up in a few words – you have yet to meet your obligation(s) to the customer. While you have every intention of fulfilling your end of the deal, there’s always a chance you may find yourself in a situation where you’re unable to deliver the products or services as planned. In this case, you may need to reimburse the customer. On the flip side of the equation, the customer may decide to cancel the order or could be unhappy with the deliverable. Again, you may find yourself needing to return the money.
Tracking deferred revenue can be time-consuming and error-prone. To provide clarity and obtain a more accurate financial position picture, many companies use the accrual accounting method for their revenue account. This accounting method recognizes revenue when the transaction is complete, rather than when payment is received.
Are You in an Industry that Uses Deferred Revenue Recognition?
Found worldwide and in many industries, companies using deferred revenue recognition include (but are not limited to):
- Professionals such as lawyers and consultants
- Airlines and hotels
- Insurance providers
- Automotive dealerships
- Construction companies
- Live event ticket services for concerts, theatre, sporting events, etc.
- Businesses that charge membership fees such as gyms, professional associations, private clubs, etc.
- Companies that charge subscription fees such as for boxes (meal kits, makeup, etc.), eCommerce companies (Amazon Prime, eBay, etc.), publishing industry (magazines), and software as a service (SaaS) organizations (Netflix, Hubspot, Salesforce, Slack, etc.)
While this isn’t an exhaustive list, it provides a glimpse of the range of industries that use deferred revenue recognition.
What You Need to Know
Although you have the cash in hand, it’s risky to dip into those funds. As we mentioned above, you may encounter a situation where the money sitting in your bank account needs to be returned to the customer. In addition to the previous examples (non-delivery of products or services purchased, cancellations, and returns), there are other situations that can become troublesome.
Say your SaaS online educational company charges an annual fee of $12,000, payable in advance, for access to training courses. This subscription-based pricing model says that to recognize revenue you’ll have multiple deliverables due at different times throughout the year. If courses are held quarterly, you’re able to recognize $3,000 at the conclusion of each 3-month period. From an accounting perspective, at the end of 6-months, you’ll have $6,000 in revenue earned and recognized and $6,000 deferred.
However, what happens if you can’t deliver a course that a student registered for at the start of their subscription? The prepaid amount of $3,000 for this course would need to remain as a liability on your balance sheet until the student is able to take the course. That is unless the student requests reimbursement of the money previously paid.
Regardless of the type of company you run, deferred revenue recognition requires careful consideration. A common mistake some companies make is including deferred revenue in their future growth calculations and predictions. Not only does this inflate projections, but it also provides an inaccurate view of your future financial potential. This could have a negative effect on your ability to attract investors or secure a loan/line of credit.
Since deferred revenue recognition is considered a liability and has inherent difficulties, does this mean it’s a bad debt? On the contrary! As long as you deliver the products and services in accordance with the contract and the customer accepts what was purchased, the money paid in advance is recognized once the products or services are delivered and accepted.
Make Deferred Revenue Recognition Foolproof
By its very nature, revenue recognition is a complex process – but it doesn’t need to be. Our blog, The Revenue Recognition Principle: A Comprehensive Guide, details revenue recognition models, accounting standards, revenue recognition policies, and more. Even if you don’t have deferred revenue on your books, effective and accurate handling of revenue recognition is critical.
All organizations need to comply with financial regulations such as ASC 606 and IFRS 15. Because deferred revenue recognition requires you to recognize revenue over time, it adds an additional layer of complexity to an already arduous process. And in the case of deferred revenue recognition for SaaS businesses, you may also encounter cancellations, upgrades or downgrades of plans, changes to services purchased, etc.
It’s not hard to see that understanding deferred revenue recognition is just one piece of the puzzle. You want and need to run your business with financial efficiency and accuracy. BillingPlatform enables you to fulfill your deferred revenue recognition processes with greater accuracy, precision, and speed. Our cloud-based revenue recognition solution automates revenue management processes, reduces errors, and enables you to meet even the most complex performance obligations with ease. Let us show you how in a personalized demo.