What is Deferred Revenue?
We’re all familiar with the idea of ‘getting now and paying later’. Deferred revenue is simply the reversal of this concept. Odds are, you’re probably paying several bills, or for services, using advanced payment already. A yearly subscription to your favorite magazine uses a deferred revenue system because they haven’t supplied you with a year’s worth of content upon your purchase. Many software companies in the Software as a Service (SaaS) space also rely on subscription-based deferred revenue because they’re supplying customers with technology services for a defined period of time with an upfront fee. Ultimately, deferred revenue hinges on the successful delivery of the items/services entailed in the agreement with the customer.
How Does Deferred Revenue Work?
Here’s an example: if you were to charge a customer in advance for a yearly subscription of your software, you will have received a customer payment that represents 12 month’s worth of deferred revenue. Note that this is not income. After each month that you supply the customer with the product, your deferred revenue will decrease by a month’s amount and that deferred revenue is converted to actual revenue. This goes on for the entire lifecycle of the subscription, culminating in the total conversion of deferred revenue to actual revenue. With deferred revenue, you haven’t earned revenue until the goods or services are fully delivered. Because you haven’t delivered on your obligations, the customer still has a technical right to the monies received. It’s for this reason that deferred revenue is considered a liability on your balance sheet.
Are there Risks with Deferred Revenue?
As with any type of business model or industry, there’s naturally some risk with deferred revenue. However, this doesn’t necessarily make deferred revenue riskier to manage than regular revenue. The major cause of concern for deferred revenue is that there must be a complete delivery of the product and/or service according to the revenue recognition principles governed by your local country and industry GAAP.
In a subscription, the company must provide the item, according to pre-set terms, for a set period of time to the customer. Essentially, the business owes the client the product for this time. While the company has been given the fee in advance, the company now has to earn it in full. If you don’t successfully provide the deliverables, or the deliverables don’t satisfy the client-subscription terms, the company is at risk of losing that income altogether, along with the customer. If there are recurring issues in fulfilling delivery, your business could gain an unfavorable reputation, which would also lower your appeal to investors. Additionally, ineffective deferred revenue management can jeopardize growth opportunities for companies seeking to use deferred revenue to expand their business.
Get in the habit of being proactive and precise in analyzing your financial data stemming from deferred revenue. Being able to drill down into specific accounts will help you grasp customer behavior, work efficiency, and let you fully gauge the strengths and weaknesses in your operation. Tracking your account volume and subscription rates will help you see whether your business has grown, but looking at specific transactions will pinpoint contributing factors to this growth. On the other hand, data analysis will help you identify major business risks. For example, if a major portion of your deferred revenue comes from a single client, you may want to increase your client base before planning a major growth initiative.
Many companies use deferred revenue to grow and expand their business. The key to this, and to sustaining your business, is looking at past financial summaries and analyzing the underlying data to see how your company’s performing and discern next steps. By fully understanding the activity that drives your deferred revenue, you’ll be more aware of your actual performance and be able to make better decisions on how you can grow and operate your business.