Deferred Revenue for SaaS: An Intro
A Gentle Intro
Software subscriptions are the bread and butter of every SaaS business. However, most SaaS companies I have spoken with incorrectly record their most important revenue source.
If you do this, I don’t blame you. Oftentimes, your accounting is outsourced to a bookkeeper or accountant. They will put together your financial statements, but will conduct the accounting on a cash or quasi-cash basis
When your bookkeeper records that one-year subscription for $12,000, for example, they record the entire revenue amount in a single month rather than spreading it over twelve months. Perhaps they are unfamiliar with SaaS accounting?
Either way, as a SaaS founder, you must understand the concept of deferred revenue. More importantly, it will become challenging to manage the financial performance of your business without proper revenue recognition. As you grow, more and more scrutiny around your month revenue will happen, so it is important to get it right at the start.
In fact, all private companies, regardless of their size, are now required to comply with ASC 606 – that’s the abbreviation of accounting regulations around this fun topic. So, when banks, investors, and others look at your financial statements, they will be expecting them to be prepared accurately according to the regulations. If you ignore them, the mistakes may end up costing you big time down the road.
What Is Deferred Revenue?
Revenue in accrual accounting is rooted in the matching principle. When you invoice a company for a one-year subscription, you have not earned that revenue yet. You earn it over the life of the subscription. Therefore, you must “park” the revenue on the balance sheet, usually in an account called “Deferred [or unearned] Revenue”.
Let’s say you sell one widget to a customer. Customer gets a widget, you get money and record the sale. Very simple and easy.
Why does it have to be parked as a liability? This is because you still owe your customer the service you sold them for the entire year, since you collected it upfront. Understanding this and SaaS and other metrics is very important in knowing the overall health of your business.
Why Is Deferred Revenue Important for SaaS Businesses?
There are several important reasons for deferring revenue and spreading it out over the subscription term. First, you have no clue about the financial performance of your SaaS business when in one month you have $100K of subscription revenue and the next month you only have $30K.
Most SaaS metrics take recurring revenue into account, such as customer lifetime value (CLV) or the CAC payback period. Using a good subscription management solution to manage your recurring revenue is essential for any modern SaaS business.
How are you handling deferred revenue? Are you still on cash basis accounting? Please share your comments or questions below.