Decoding deferred revenue in SaaS: A guide for finance leaders

What is deferred revenue?

In the simplest terms, deferred revenue is when customers pay upfront for products or services prior to receiving them. 

Understanding deferred revenue is particularly important for SaaS companies because they sell their services through a subscription model, where customers pay in advance, usually for an entire year’s worth of service to be delivered over the next 12 months. 

However, the company hasn’t really earned this money yet. Rather, it can only earn it when services have been delivered. This is why it’s called deferred revenue – it’s revenue that the company expects to earn based on a contract but cannot recognize on its income statement until it actually delivers the services. 

In keeping with this concept, deferred revenue shows up in your balance sheet as a liability. When a customer pays upfront for an annual subscription, your company has a contractual obligation to render services throughout the year. Until these services are delivered, the prepayment represents a debt the company owes to its customers. 

Revenue recognition vs. deferred revenue

Revenue recognition and deferred revenue are both related accounting concepts that are often confused. However, they are not the same thing. Here are the key differences:

• Revenue recognition: This is the process of recording revenue when it's actually earned. For SaaS, revenue recognition typically happens at the end of each month after the service for that month has been delivered, not when the cash was collected. 

• Deferred revenue: On the other hand, this is a balance sheet liability that represents advance payments received for services not yet delivered. Deferred revenue translates into recognized revenue over time as services are delivered. 

While both the terms are connected (deferred revenue becomes recognized revenue), they represent different stages in the accounting process.

Why deferred revenue is important for SaaS companies to understand

Deferred revenue is important to SaaS companies in a lot of ways. Tracking deferred revenue helps businesses with several important financial planning and analysis (FP&A) activities: 

• Cash flow management: While advance payments can provide a lot of cash for a SaaS company to run its business, they also represent a liability. Tracking deferred revenue is key to helping leaders monitor future obligations so they can effectively manage cash flow to meet them.    
• Financial reporting: Financial reporting is a core finance function for any business. Tracking deferred revenue not only provides for more accurate financial reporting but also helps ensure compliance with industry-accepted accounting standards. 
• Financial forecasting: Forecasting deferred revenue is an important aspect of financial planning, giving businesses a clearer picture of their current financial health so they can plan for the future. Tracking deferred revenue on a regular basis makes forecasting it much easier.   

What are the relevant accounting standards for deferred revenue?

There are several industry-accepted accounting standards and regulations that govern the recognition of deferred revenue. While most of them share core principles, each standard provides specific guidelines: 

International Financial Reporting Standard 15 Revenue from Contracts with Customers (IFRS 15) is a globally accepted standard. It specifies that the revenue should be recognized as a company fulfills its performance obligations, not at the point of payment.

FRS 102 The Financial Reporting Standard applicable in the UK and Republic of Ireland (September 2024) mandates that revenue is recognized when earned. This standard closely aligns closely with IFRS principles and is used by small and medium-sized companies in the UK and Ireland.

Generally Accepted Accounting Principles (GAAP), published by the Financial Accounting Standards Board (FASB), state that for US companies, deferred revenue should be recognized progressively, according to when services are delivered or goods are provided.

Accounting Standards Codification (ASC) 606 was developed by the FASB and pertains specifically to revenue from contracts. With regard to reporting, ACS 606 states that a company’s financial reporting should reflect its remanming performance obligations, which is the sum of its deferred revenue plus any money contracted but not yet invoiced. 

International Accounting Standard 18 Revenue (IAS 18) also includes guidelines on revenue recognition that are closely aligned with IFRS 15. 

While these standards have distinct requirements, they all share the common principle that revenue should be recognized as services are delivered, not when cash is invoiced or received. 

For subscription-based companies, these standards mean that revenue is typically spread across the duration of the contract. For example, a yearly subscription contract’s revenue would be recognized monthly over the twelve months, providing a clearer view of financial performance over time.

The impact of deferred revenue on financial statements 

Deferred revenue is a balance sheet liability when cash is received upfront. As the revenue is recognized each month (or according to the performance obligation), it moves from the balance sheet to the income statement, impacting reported revenue.

This way, it impacts the balance sheet and income statement when the revenue is recognized. Similarly, it impacts the cash flows upon the receipt of payment from the customer. 

• Balance sheet: When a SaaS company receives cash for the services yet to be delivered, it has a contractual obligation to provide services over the subscription period. Until the company delivers these services, the advance payment represents a debt owed to the customer. This debt shows up as a liability on the balance sheet.
• Income statement: As the company delivers its services, it is essentially paying down the debt it owes to the customer on a monthly basis. After the company has delivered its services each month, it can “recognize” another month’s worth of deferred revenue on its income statement as earned income, and the corresponding liability on the balance sheet (the deferred revenue) decreases by the same amount. 
• Cash flow statement: The advance payment amount is recorded in the cash flow statement when received.  

How to calculate deferred revenue for a SaaS business

The formula for calculating deferred revenue is simple. It’s the value of invoices minus recognized revenue:

In the context of deferred revenue, the term “invoices” reflects the total amount of money invoiced and paid by your customers in advance of receiving services. For SaaS companies with traditional subscription pricing – a flat monthly fee – this is usually the full value of the contract. However, that’s not always the case. 

For companies that use consumption-based (aka usage-based pricing), the amount invoiced would be based on how much of your services your customers have used.

Here’s a breakdown of how it works:

1. Full Contract Value: When a company enters into a contract that involves future delivery of goods or services (like subscriptions or service contracts), the total value of the contract is recorded as deferred revenue until the services are rendered or the products are delivered.
2. Invoiced Amount: If a portion of the contract is invoiced in a specific month, the revenue recognized in that month will be based on the services rendered or products delivered during that period as opposed to the total contract value. The remaining balance would continue to be recorded as deferred revenue until it is earned. 
3. Recognition Principle: Under the revenue recognition principles (like ASC 606), revenue should be recognized as the company fulfills its obligations under the contract. This means that until the service is delivered or the product is provided, the revenue remains deferred.

In summary, while the invoiced amount reflects the revenue that is currently being recognized, the full value of the contract is considered when calculating deferred revenue until the services are completely provided.

To help drive this home, here’s a couple of examples with two different pricing models. In both cases, the customer pays the entire amount contracted in advance of receiving services. 

Subscription-based pricing

‍In a subscription model, the customer pays upfront for a service over a fixed period. Since the service is delivered over time, the company recognizes revenue gradually. 

For example, a customer signs a $100,000 contract for a 12-month subscription. The customer is invoiced and pays for the entire value of the contract upfront. Each month, the company recognizes $8,333 (one twelfth of the annual subscription) as revenue, while the rest is tracked and reported as deferred revenue, a balance sheet liability, until fully recognized over the contract period.

Usage-based pricing

‍Usage based pricing models can be very complex, especially when it comes to calculating deferred revenue. For our example, we’ll use a very simple pricing structure in which customers pay an annual fee upfront for a specific amount of usage. 

Let’s say a customer buys 100,000 push notifications for $6,000, usable over 12 months. If the customer uses 5,000 (5% of the total allowance) in the first month, $300 (5% of the amount paid), can be invoiced and recognized as revenue. In the second month, if the customer uses 10,000 (10% of the total allowance), then $600 (10% of the total amount paid) can be recognized, and so on. 

With usage-based pricing models, revenue fluctuates based on how much of the service the customer actually uses each month as opposed to a set monthly amount.  The invoice provides the means for the company to track usage, which for those with usage-based pricing, translates into earned income. 

Tips for managing deferred revenue

Managing deferred revenue in SaaS companies is inherently challenging, but there are some things you can do to make it easier:

• Periodically review your revenue recognition process: Regularly reviewing deferred revenue to confirm that revenue aligns with service delivery and contract terms will help ensure accurate and timely recognition.
• Keep track of contract renewals and renewal rates: This is important because  it’s not uncommon to have a time lag between the contract end date and when the customer actually renews. For example, if a contract is up for renewal in January 2025 but renews in February instead, January will show unbilled revenue. Deferred revenue tracking will resume in February. Monitoring renewals will help you more effectively manage deferred revenue and more accurately forecast cash flow.
• Make sure everyone is on the same page: Depending on your organizational structure some aspects of revenue recognition may be handled by the accounting team while the finance team may handle others. Make sure everyone involved in the process fully understands how revenue recognition works in your business so you can avoid any issues in tracking and reporting deferred revenue.  

Leveraging technology to make managing and forecasting deferred revenue easier

Tracking deferred revenue schedules can be simple enough if you’ve just started your venture. But what happens when your ARR grows?

Integrating your accounting system with one or more technologies can help you automate calculations, streamline reporting, and reduce manual errors as your business grows. 

For example, some FP&A software tools can automate the calculation of deferred revenue each month making it much easier to track. There are also financial forecasting tools that can help you more accurately forecast deferred revenue. 

Drivetrain – a comprehensive and robust FP&A platform purpose built for SaaS – can do all of these things and more. Drivetrain easily integrates with any accounting system and other systems to automatically consolidate all the data you need for managing and tracking deferred revenue into one platform. You can also automate your financial reporting, and with powerful forecasting tools built-in, reliably forecasting deferred revenue couldn’t be easier. 

Take a closer look at Drivetrain today to learn how it can support all your FP&A needs.