If you are a SaaS business, you must read this article to understand:
- What is Deferred Revenue in SaaS Business?
- How To Record Deferred Revenue Journal Entry?
- How to Calculate SaaS Deferred Revenue?
SaaS Deferred Revenue
Deferred Revenue refers to the revenue that a SaaS business generates before delivering the product or service to the customer. It refers to the payment that customers make to a SaaS business before such a business delivers the product or service to them.
Thus, deferred revenue is separate from the normal revenue that a business generates. In the case of the revenues generated in the normal business cycle, a business delivers the product or service to the customer, issues an invoice, and receives payment from the customer 30-60 days after the invoice date.
In such a scenario, the business recognizes revenue along with an offsetting Accounts Receivable entry. Eventually, the cash received offsets Accounts Receivable when the customer pays the invoice.
However, this is not the scenario in the case of a SaaS company as it receives payments from customers in advance. In such a scenario, there is no Accounts Receivable account to offset the cash payment received from a customer. This is because a SaaS business does not recognize the cash received from the customer as revenue in its books of accounts.
Instead, such advance payment is showcased as a liability in the balance sheet of a SaaS company. The liability so created represents the obligation of the SaaS company to deliver the product or service to the customer at some point in the future. This liability is called Deferred Revenue.
This means as the SaaS business delivers the product or service to the customer, the Deferred Revenue account will decrease. Eventually, such an account will become zero. The offsetting accounting entry in such a case would be recognition of revenue.
SaaS businesses often have Deferred Revenue on their Balance Sheets. That’s because their customers make upfront payments for obtaining annual subscriptions.
Why Do SaaS Companies Have Deferred Revenue?
As per ASC 606, a SaaS business must record or recognize revenues into its books when it earns such revenue and not when it posts the related invoice or collects the related cash.
This means a SaaS business can recognize revenues into its books only when it transfers the promised goods or services to the customers against such revenue. That is, a business must recognize revenues when it satisfies a performance obligation. The performance obligation will get satisfied by transferring a promised good or service to a customer. In other words, when the customer obtains control of that good or service.
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In the case of a SaaS business, a company examines its billing data to know the revenue recognized in its books. This is because the revenue is recognized as per the accounting standards (ASC-606).
SaaS billings refer to the total billing amount or the sum of billings of all the customers of a business. Such an amount can be calculated monthly or annually.
Further, the customers can pay against such billings in advance for a year or periodically throughout the lifetime of the contract, that is, monthly or quarterly.
Note that the timing of billing in a SaaS business determines how much deferred revenue it has?
Typically, SaaS companies bill enterprise customers in advance annually with 30-day payment terms. This is the case with new subscriptions. In case the existing customers want to renew their subscription, a SaaS business bills customers 30 to 45 days prior for renewals.
Note that customers make a small advance, upfront payments in cash to a SaaS business for utilizing its product or service over the given period. The SaaS business is yet to deliver the product or related services to the customer.
This is unlike the large on-premise software license payments that were made either upfront or on delivery. That is, customers are increasingly mortgaging the cost of the technology over a series of monthly payments or simply rent capacity.
This is Deferred revenue. It is the payment that a SaaS business receives for the future delivery of products or services to customers. In other words, deferred revenue represents the revenue that the SaaS business has not yet earned and has not delivered a product/service.
GAAP treats deferred revenue as a liability. As the SaaS product or service is delivered, it is recognized proportionally as revenue.
Further, SaaS business records deferred revenue as a current liability if the pre-payment term is 12 months or less. Whereas if the prepayment term is for a period in excess of 12 months, it is classified as a long-term liability (debt).
Why Deferred Revenue Is Important For SaaS Businesses?
The following are the three reasons that make Deferred Revenue one of the key SaaS metrics.
I. Positive Cash Flows For SaaS Business
The first reason is that a SaaS business receives payments in cash upfront from its customers. This has a positive impact on the cash flows of a SaaS business. Further, SaaS businesses with short-term deferred revenues may operate with a negative working capital balance. This happens primarily because of the advance customer payments. The advance customer payments create a Deferred Revenue liability on the balance sheet of a SaaS business instead of creating Accounts Receivable asset. This increase in Deferred Revenue Liability reduces the Working Capital needs of a SaaS business.
II. Indicator of Competitive Positioning
A SaaS business carrying a Deferred Revenue balance indicates that such a business has competitive positioning or has uniqueness in its product or service. How? A business that offers its customers something unique or differentiated may require upfront payments from them.
For instance, Salesforce.com offers the gold standard for CRM software. Thus, it requires upfront payments from its customers.
III. Lower Incremental Cost
It is often noticed that SaaS businesses with Deferred Revenue have a comparatively low marginal cost associated with its incremental revenue. This is especially the case with companies offering digital products like software, data, etc. Such products demand very little additional Costs of Goods Sold (COGS) for an additional customer.
Note that companies with lower marginal costs on additional or incremental revenues typically are able to scale more quickly and achieve higher levels of overall profitability.
Also, SaaS companies with Deferred Revenue on their Balance Sheets are able to attract investors as compared to the businesses that do not display such revenues.
Deferred Revenue Journal Entry
I. Journal Entry to Record Invoice and Deferred Revenue
Say SaaS business invoices the end-user for a one-year subscription of the SaaS product at $24,000 on January 1, 2021. The SaaS business has not earned this money yet as it has not delivered the product or the related service.
In fact, it earns the money over the term of the subscription. As a result, the SaaS business creates a deferred revenue balance in its balance sheet. Deferred revenue is a payment a user of the SaaS product makes for products or services to be delivered in the near future.
As a result, the SaaS business that sells such a product to the user records the payment as a liability as it has not yet been earned. The journal entry to record the invoice is as follows:
|Accounts Receivable (Debit)||24,000|
|To Deferred Revenue (Credit)||24,000|
It is important to note that the above journal affects only the balance sheet of the SaaS business. At this stage, it does not have an impact on its income statement.
II. Journal Entry to Recognize Subscription Revenue
Suppose, it’s February 1, 2021, and it’s time to close the books of accounts for the month of January 2021.
During the time of closing of books for the month of January, the SaaS business owner debits deferred revenue for $2,000 and credits the subscription revenue for $2,000. This reduces the SaaS business’ deferred revenue liability from $24,000 to $22,000, and its income statement now showcases $2,000 of subscription revenue.
|Deferred Revenue (Debit)||2,000|
|To Subscription Revenue (Credit)||2,000|
|By Subscription Revenue (Credit)||2,000|
|Deferred Revenue (Liability)||2,000|
The SaaS business continues to reduce the Deferred Revenue balance each month until it becomes zero. Note that we start with the Deferred Revenue balance of $24,000 in the month of January 2021. Each month until June 2021, the SaaS business reduces this balance by $2,000 and records it as subscription revenue on its Income Statement.
SaaS Deferred Revenue Calculation
SaaS Deferred Revenue appears as a current liability in the balance sheet. It reflects the obligation of the SaaS business to provide services over the term of contracts. These are the contracts for which the customers have paid in advance. Thus, treating Deferred revenue as a liability in the SaaS Balance Sheet is in line with the accrual concept of accounting.
To understand the accounting treatment for SaaS deferred revenue, let’s consider the example worked out by Modano. There are scenarios considered in this example:
- Scenario I: Contract without any complexities
- Scenario II: Contracts rolling over each other cumulatively; and
These scenarios represent the manner in which a SaaS business needs to record deferred revenue into its books of accounts.
How Should Deferred Revenue Be Recorded?
Scenario I: Contract Without Any Complexities (Uncommitted Monthly Users)
Uncommitted monthly users in the case of a SaaS business give an ongoing monthly charge to the business, unlike contracts in which users sign contracts for a fixed period at a contracted rate.
Thus, there are no contract commitments or prepayments in the case of the uncommitted monthly users.
In our example, a SaaS business prepares forecast estimates for the growth in new users. To do so, it takes the historical income statement into consideration.
Many SaaS businesses focus on acquiring users in addition to focusing on tracking users. To determine the number of acquired users, businesses prepare a schedule of forecast leads and conversion rates as shown below:
By considering the above assumptions, the balance for closing users at the end of December 2021 comes out to be 25,130.
Note that this scenario represents the calculation of revenue and growth in users considering the uncommitted monthly users. Thus, there are no specific contracts or commitments. Furthermore, there is no specific price linked with each user based on when each of them started using the SaaS product or service.
In addition to determining the number of customers acquired, a SaaS business also considers customers acquired organically via word of mouth or digital media. Thus, to track such growth in new users, the SaaS business determines forecasted estimates as shown below.
Thus, using the above assumption of 1% growth in new users, the closing users at the end of December 2021 increases to 27,053.
In addition to user acquisition and the inbound funnel, SaaS businesses also monitor the customers they lose. The rate at which SaaS businesses lose customers over a period of time is referred to as user churn.
Thus, a SaaS business will have a lower churn rate if the product or the service that it sells is of high quality. The better the product, the lower the churn rate. Then, the lower the churn rate, the higher the value of any user.
The following image showcases a 12-month profile of user churn rates for a SaaS business with regards to its uncommitted monthly users.
Note that the SaaS business expects to lose 2.5% of its opening users each month. For instance, the business expects that 49 customers will abandon its product or service in the month of March 2021.
After undertaking calculations using the above assumptions, the closing users at the end of December 2021 are forecasted to be 24,887.
Thus, the SaaS business adjusts the conversion of leads and user churn into the Opening Users balance to calculate its ongoing user base. The ongoing user base of the SaaS business is nothing but the closing user balance each month.
Once the SaaS business calculates the closing balance of users each month, it then calculates the revenue derived from these users. Such revenue is calculated by charging the closing balance of customers with the ongoing monthly subscription fee.
Suppose, the SaaS business sells its product or service at a monthly rate of $60 per user. This rate applies to both the opening/existing and new users.
Thus, the SaaS Deferred Revenue financial model as showcased above now has a forecast of users as well as a monthly charge. This results in creating forecasted revenue for the business.
Note that the formula for the Forecasted Revenue for the SaaS business is simply opening plus new users, multiplied by the monthly charge. Accordingly, the forecasted revenue for December 2021 month is $1,518,400.
The above images showcase the forecasted figures for users and revenue for a SaaS business. A SaaS business must also consider historical data to determine revenue growth and business valuation.
Thus, a SaaS business must incorporate its financial and operational data for FY20 within the historical income statement for SaaS revenue analysis.
Note that the historical data related to the user numbers are more important for a SaaS business to consider. This is because the users give recurring revenue to a SaaS business which is of utmost importance for it.
Note that row 62 represents the monthly charge of $50 per user for the FY20. Considering this rate as the best average rate at which the users are charged, the SaaS business forecasts the price of $60 per user per month for FY21 starting January 2021. Such a rate will apply to the ongoing users as well as the new users brought on board in FY21.
As we can observe, the historical data for the closing balance of a number of users helps a SaaS business to determine forecasted data of closing users and new users. Note that the last historical period’s (FY20) closing users data provides the base to forecast user numbers for the upcoming financial year (FY21).
Likewise, the historical data for new users helps a SaaS business to calculate historical lead conversion and user churn rates. Both these financial performance metrics are important for a SaaS business
According to the above assumptions, the SaaS business has 2,721 closing users in December 2020. This provides a base for the SaaS business to forecast a number of users and revenues for FY21.
A positive change in the number of closing users of a SaaS business represents the net new users. Whereas, a negative change in the number of closing users of a SaaS business represents the churn rate.
Note that a SaaS business calculates the historical conversion rates using the leads data. Such data is extremely important for a SaaS business as it helps the business in understanding the manner in which its inbound funnel performs.
As in the example above, the projected closing users at the end of December 2021 are now 27,372 users.
Another metric that a SaaS business must consider is the historical user churn. Historical user churn data represents the rate at which customers abandon the SaaS product or service. The historical user churn is calculated using the previous period’s closing users, leads, conversation rates, and new users assumptions.
As a result, a SaaS can showcase the relationship between opening users, new users, user churn, and closing users in the following manner:
Closing Users = Opening Users + New Users – User Churn
User Churn = Opening Users + New Users – Closing Users
Thus, for July 2020:
- User churn was 16 users,
- Opening users were 732 users
- New users were 255, and
- Closing users were 971 users
Note that the SaaS business with 16 user churn and 732 opening users had a churn rate of 2.2% during July 2020. This is one of the key SaaS metrics that helps a business in understanding its growth potential.
Scenario II: Prepaid Subscriptions
Another pricing model that a SaaS business may consider to record deferred revenue is the Prepaid Subscriptions Model. In this model, users pay a lower contract price in case they prepay their entire contract on commencement itself.
Let’s consider the same example as above to understand this approach.
- Contract duration is 6 months
- Price of contract is $180
- Contract Price reduced to monthly cost of $30 per user
Note that in this scenario, the SaaS business is satisfied earning reduced revenues at
lower risk. The risk is lower because the users pay the entire contract amount upfront thus eliminating the user credit risk.
Though the SaaS business earns reduced revenues at lower risk, this pricing model is challenging to interpret. There is no connection between the cash inflows from subscriptions and the timing of when that revenue is earned.
For this model, the SaaS business considers ‘Upfront Payment Users’ in place of the ‘Uncommitted Monthly Users’ as showcased below.
Note that the upfront payment users component within the SaaS revenue sheet contains detailed analysis of both contract prepayments and deferred revenue as shown below:
Thus, including the prepaid subscriptions analysis in a rolling SaaS financial model increases the complexity. This is because in this scenario the SaaS business owner must align the recognition of revenue from contracts with their lifespan. They have to align contract revenue with the contract life despite the upfront payments made by the users.
To align recognition of contract revenue with the contract lifespan, SaaS business owners create a deferred revenue balance on the liability side of the balance sheet. In addition to this, they report the revenue recognized each month until the contract life on the income statement.
Let’s consider the following example to understand this approach:
- Contract Duration (in Months) = 6
- March 2021 Leads = 25,000
- March 2021 Conversion Rate = 4%
- March 2021 Prepaid Contract Value = $180
- September 2021 Contract Renewal (%) = 0%
The last assumption regarding Contract Renewal is taken as 0%. This is done to present a single isolated contract cycle of users, prepaying a 6-month contract but not renewing for simplicity.
A SaaS business would undertake the accounting treatment of Prepaid Contract Value of $180 in the following manner:
- Based on the accrual-based accounting concept, the SaaS business would recognize a monthly revenue of $30 over a period of 6 months.
- Then, it would create a liability of $180 in its balance sheet as a deferred revenue balance.
Note that there is a timing difference between when the revenue is recognized and when the cash is received for the given contract. Such timing difference leads to the creation of deferred revenue balance on the liability side of the balance sheet.
How? Well, assume that the contract is prepaid on the first day of March 2021. This means the customer pays $180 advance cash even before the SaaS business provides the product or service. This means it is yet to earn revenue. Such prepayment impacts the financial statements of the SaaS business in two ways.
First, it increases cash by $180 and creates a deferred revenue liability on the balance sheet of the same amount as shown below:
The SaaS business then releases the deferred revenue liability to the income statement by recognizing revenue in each of the next six months, including March 2021 itself. This release of the Deferred Revenue Liability sends such revenue to the income statement and reduces the deferred revenue balance with each month presented as follows:
Note that the upfront payment of $180 is invoiced in March 2021. This amount is then added to the closing deferred revenue balance. Then, the revenue of $30 each is recognized as forecast income statement revenue in each of the six months from March 2021. Also, the SaaS business reduces the closing forecast deferred revenue balance is reduced by the same amount each month.
See the Deferred Revenue Waterfall Excel image below to understand the effect of the above transaction on the income statement and the balance sheet of the SaaS business.
Note that the recurring revenue of $30 is recognized each month in the income statement of the SaaS business.
Besides this, the deferred revenue balance is showcased under the current liabilities. This amount declines each month by $30 per month over 6 months. It keeps on declining till the deferred revenue balance reduces to zero from $180.
Let’s understand the impact of the above journal entry on the cash flow statement of the SaaS business. The cash receipts reveal the following impact on the cash flow statement:
- Cash receipts of $180 for March 2021 consist of $30 in revenue and a deferred revenue movement of $150.
- Cash receipts amounting to zero from April 2021 to July 2021 consist of $30 in revenue and a negative deferred revenue of $30.
This is how a SaaS business needs to show the impact of a deferred revenue transaction in its income statement, balance sheet, and cash flow statement. In this, revenue is showcased as a cash receipt along with a cash-to-balance-sheet differential.
Then, there can be a case of cumulative deferred revenue balance while preparing Deferred Revenue Waterfall Excel. The cumulative deferred revenue balance consists of an ongoing mix of contracts. This increases the complexity of the analysis as the closing deferred revenue balance becomes an ongoing mix of contracts at various points in the entire duration of a contract.
Let’s understand the impact of the cumulative deferred revenue in the financial statements above.
As you can see, the analysis becomes challenging to understand when the deferred revenue balance aggregates multiple rolling contracts.
For instance, the closing forecast deferred revenue balance on April 21 is $417,360. This balance is a combination of:
- (2 months/6 months) x January 2021 contract ($149,040) = $49,680
- (3 months/6 months) x February 2021 contract ($164,160) = $82,080
- (4 months/6 months) x March 2021 contract ($180,000) = $120,000
- (5 months/6 months) x April 2021 contract ($198,720) = $165,600
Thus, the Cumulative Deferred Revenue for the Month of April 2021 is: $49,680 + $82,080 + $120,000 + $165,600 = $417,36.
Also, the revenue of $115,320 for April 2021 is one month of each of the above four 6-month contracts: $24,840 + $27,360 + $30,000 + $33,120 = $115,320
The next scenario while preparing Deferred Revenue Waterfall Excel is the rolling deferred revenue scenario. It combines the revenue and operational data for historical and forecast periods. In fact, historical balance sheet and forecast activity drive the deferred revenue through the rolling functionality.
To understand this approach, let’s assume that the users started making upfront payment for the SaaS product or service in October 2020. This means that deferred revenue balance showcased in the historical balance sheet of the SaaS business was created during the last 3 months of activity from FY20.
Note that the SaaS Deferred Revenue figures as showcased in the above image represent the the creation of deferred revenue balance. In addition to this, the image also showcases the partial reduction of the deferred revenue balance from the first three months of the SaaS business’ prepaid user group. Note that the prepaid balance is split out by month of contract commencement.
Further, the SaaS business also showcases the remaining term of prepaid subscriptions sold in October 2021 – December 2021. To calculate these amounts, it makes use of the historical deferred revenue recognition assumptions as shown below:
Note that the SaaS business created the Deferred Revenue balance in October 2020. Then, it reduced the Deferred Revenue balance amount in a linear fashion over aperiod of 6 months up to March 2021. This is done via recognizing a revenue of $12,960 in each period.
The closing deferred revenue balance of $183,660 for FY20 is reduced over the subsequent 6 months as showcased below:
Note that it is important for SaaS businesses to understand the fundamentals of reducing the Deferred Revenue balance to understand modeling and interpretation of the analysis of prepaid contracts.
The reduction in the Deferred Revenue balance does not mean release of revenue to the SaaS income statement from the balance sheet. In fact, it is just a cash shield of non-receipt that is calculated to ensure that forecasted revenue does not also render into cash inflow. This effect is shown in the image below.
Note that the data in the above image is the historical revenue from the first three months of prepaid subscriptions from October 2020 to December 2020. This data is used for prepaid users analysis.
The following revenue worksheet showcases the historical users, leads, and new users.
In the prepaid contract value cell, the SaaS business assumes the prepaid contract value for October 2020 to be $180. Considering the previous image, the new contracts created in October 2020 had a total value of 432 users * $180 = $77,760.
As a result, each month the total for the deferred revenue balance to be reduced over a period of 6 months would be: $77,760/6 months = $12,960
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