When you take payments as a business, the way you track them as revenue depends on the method you use for providing the goods or services. If you collect payment at the time of service (or after), revenue recognition can happen at the time of payment. If you take payments in advance for software subscriptions, ticket sales, contract work, or other services, you’ll need to use deferred revenue recognition. Let’s explore how you can ensure that your revenue recognition meets regulatory guidelines, with a few tips to make it easier.
Understanding Deferred Revenue Recognition in Accrual Accounting
For many organizations, payment comes in advance of goods or services. Although you might record the payment, you don’t track it on your income statement until the transaction is complete. This concept is called “deferred revenue recognition,” unlike immediate or accrued revenue, where payment is received at the point of service (or afterward). Common examples include:
- Advance sales of gift cards
- Event ticket sales
- SaaS subscriptions
- Prepaid maintenance contracts
- Club memberships
Businesses rely on the promise of goods or services as a way to handle demand and control the cash flow for their expenses, although they must reconcile these obligations in their accounting. Until the services or goods are rendered, you would list the payment as a liability on your balance sheet.
Accrual accounting principles call for organizations to put their revenue and expenses for each transaction in the same period. The chief premise for deferred revenue accounting is honesty and transparency in reporting. A company using deferred revenue recognition cannot use the payment to inflate their revenues before they actually meet their obligations. This process provides to stakeholders a full picture of the business’s income, cash flow, and liabilities. Accurate accounting of deferred revenue is also a key component of compliance with GAAP and IFRS standards, which can boost investor confidence and audit readiness.
When Is Deferred Revenue Recognized as Earned Revenue?
As a business provides goods or services for the advance payment, they can proportionally turn unearned revenue into earned revenue. The rate at which deferred revenue can become recognized revenue depends on transactions and time periods. Consider these scenarios:
- A business offering preorders for goods can resolve the obligation as soon as the customer receives the product.
- An organization selling gift cards can recognize the revenue as the gift card is spent.
- An SaaS company offering access to a service on a prepaid, annual basis can break the total amount of the payment into 12 equal pieces and recognize one piece per month, for services rendered.
- A contractor taking half the payment in advance can recognize portions of the payment at relevant project milestones.
As such, although these companies cannot start recognizing unearned revenue right away, they may be able to list revenue over time.
Wondering when deferred revenue is recognized? On the balance sheet, businesses can see these liabilities turn into earned revenue as they meet their obligations. The change shows a decrease in overall liabilities while increasing revenue and paints an accurate picture of the company’s financial function. This practice is also a critical component of IFRS 15 and ASC 606 compliance.
Navigating Compliance: Regulatory Standards for Deferred Revenue
Although the premise for recognizing revenue based on advanced payment for goods or services may seem fairly simple, it’s often more complicated. ASC 606 and IFRS 15 guidelines require these assessments:
- Contract Identification: What is the contract between business and customer, and how does it play out?
- Identifying Performance Obligations: What has the business promised the customer in exchange for payment?
- Transaction Price: What will the business collect in exchange for the goods or service?
- Allocation: How should the business allocate the price in relation to the contract obligations?
- Satisfaction of Obligations: When does the customer gain control of the asset (either product or service), allowing for revenue recognition?
Maintaining documentation with clear contracts and policies describing fulfillment of obligations is critical. Businesses providing SaaS, media, or professional services face additional layers of complication. Pricing based on usage, tiers, or upgrades call for careful reporting.
Until the obligation is satisfied, the company must treat the payment as a liability. Monitoring changes in each revenue recognition principle can help you navigate the nuances of these accounting requirements, particularly if your company is multinational.
Impact of Deferred Revenue on Financial Statements & Reporting
Handling deferred revenue accounting requires specific approaches to preparing financial statements and regulatory reporting. The impact of deferred revenue recognition calls for you to pay attention to these concerns:
- On your revenue schedule or balance sheet, classify liabilities as current (less than a year) or non-current (longer than 12 months).
- Convert liabilities into earned revenue by categorizing fulfilled obligations, even if the revenue must be recognized in part over time.
- Balance cash flow to acknowledge which funds count as revenue or profits and which count as a guarantee for existing performance obligations.
- Figure liabilities into the assessment of the company’s liquidity, leverage, and working capital ratios.
- Consider how investors may look at significant deferred revenue, as an indicator of high demand and high obligations.
- Keep classification of liabilities clear and accurate, to maintain an audit trail and avoid investor distrust.
Taking care to attend to each of these issues can minimize risk of an audit, while keeping business operation running smoothly.
Leveraging Revenue Management Software to Automate Deferred Revenue Recognition
Balancing all these requirements can seem overwhelming, but you can rely on expert software to help. Revenue recognition software provides the following convenient features:
- Automation: Using software to handle financial data entry reduces human error, streamlines the process of month-end close, and complies with regulatory guidelines.
- Real-Time Insights: Dashboards and analytics allow you to see what needs to be done and monitor your overall performance.
- Configurable Systems: Software systems are easy to configure to your unique revenue schedules, milestone billing, currency needs, and audit-ready reporting.
- Integration With Enterprise Systems: Software options integrate seamlessly with other enterprise systems, such as CRMs, ERPs, and payment gateways.
- Compliance Support: Systems provide critical details for ASC 606/IFRS 15 reporting requirements, helping you to maintain a clear audit trail.
If you integrate software into your deferred revenue recognition accounting, you gain the benefit of operational efficiency. These services simplify the process of data entry and reconciliation, streamlining function between your finance, sales, and customer service teams.
Real-World Examples of Deferred Revenue Recognition
Although recording deferred revenue is the standard for several industries, it looks unique depending on the situation. Here are a few examples:
- SaaS Subscriptions: A $500 usage-based subscription requires reporting at a set interval, usually monthly. The company deducts the cost of usage and other fees from the advance payment, classifying that amount as revenue.
- Event Ticketing: A $100 event ticket is listed as a liability until the event has occurred, allowing the business providing the event to recognize the revenue.
- Insurance Premiums: A company charging $600 every six months for auto insurance can recognize $100 per month in revenue, deducting that amount from the deferred revenue balance.
- Milestone-Based Billing: A contractor charging $5,000 advance payment for a service lists two benchmarks, recognizing $500 after the first day and the remaining $4,500 at the end of the project.
For example, if you receive $600 to cover all the costs for an annual SaaS subscription, that payment is recorded but immediately put in as a deferred revenue liability. Your deferred revenue journal entries show that each month you provide the service to the customer, you move $50 from the liability and recognize it as revenue.
This approach allows you to maintain funds available for cancellations, upgrades, or refunds. If someone cancels a service partially through, you can provide a prorated refund. In this case, the liability requires updating.
Best Practices for Managing Deferred Revenue to Ensure Financial Accuracy
Tracking deferred revenue can be easily managed, if you follow these best practices:
- Provide clear documentation on contracts, so that it is easy to determine how and when to classify deferred revenue.
- Automate data entry and calculation, to reduce errors and minimize workload.
- Classify short-term and long-term balance sheet liabilities, so that the record reflects the duration of these obligations.
- Review your deferred revenue account schedules monthly or more frequently to spot errors quickly.
- Streamline policies between finance, sales, and legal teams to provide consistent policies and customer communication.
- Maintain a detailed record for regulatory reporting and audit evaluations.
- Use data to forecast cash flow and assist with strategic decision-making.
Building accuracy and transparency into your processes can minimize problems in reconciliation and reporting.
Common Mistakes in Deferred Revenue Recognition (and How to Avoid Them)
Even though the deferred income accounting method is common, companies can still make mistakes that cost them time and money. Common problems include:
- Premature Revenue Recognition: Create accurate reporting processes to avoid inflating sales records or failing an audit.
- Inconsistent or Unclear Policies: Standardize your policies and confirm that sales, accounting, and customer service teams receive proper training.
- Incorrect Liability Classification: Lumping current and noncurrent liabilities together can increase risk of reporting penalties, which you can resolve by following accounting standards accurately.
- Relying on Spreadsheets: Upgrade systems to software that can handle data entry, reduce risks of errors, and avoid version control problems that crop up in obsolete accounting approaches.
- Failure to Update Records: Automate record-keeping, so you do not make reports or forecasts based on outdated information.
Streamlined processes and systems across the company can reduce your risk of these mistakes.
Key Takeaways on Deferred Revenue Recognition
If you want to maximize your investors’ trust and compliance with regulatory guidelines, accuracy is key. SaaS revenue recognition requires careful attention to your business’s transactions and how they affect your ability to turn obligations into revenue. Automating your contract liabilities accounting can help to simplify and streamline your efforts. It increases output and precision while decreasing manual effort, even for complex billing models. BillingPlatform provides a complete solution able to automate revenue recognition, integrate with your existing billing systems, and support your business’s regulatory requirements. To learn more, request a personalized demo.
