Deferred revenue for SaaS: why cash in isn't revenue

Deferred revenue is cash you have collected for software you have not yet delivered. Under US GAAP it sits on the balance sheet as a liability and moves to revenue one month at a time as you provide the service, so a $24,000 annual prepay produces $2,000 of revenue per month, not $24,000 in the month the customer pays.

If you sell annual or multi-year contracts, this is the first accounting idea that will make your books look "wrong" when you compare them with your bank balance. It is not wrong. It is the rule, and investors and auditors check for it.

What deferred revenue actually is

When a customer pays before you deliver, you owe them something: twelve months of access to your product. Accounting treats that obligation as a debt of a special kind. You do not owe them money back (unless they cancel and are entitled to a refund), you owe them service.

The standard that governs this is ASC 606, Revenue from Contracts with Customers. It says you recognize revenue when you satisfy a performance obligation, meaning when the customer receives the thing they paid for. For a typical SaaS subscription, the customer receives access continuously across the term, so revenue is recognized evenly over that term. This is called ratable recognition. Whether a fee counts as part of the subscription or as its own promise is decided by the five steps of ASC 606, worked through one SaaS contract.

ASC 606 calls the balance a contract liability. Most companies, and most software, label it "deferred revenue" on the balance sheet. They mean the same thing. You can read the standard and the FASB's own summaries at fasb.org.

Why cash in isn't revenue

Cash and revenue answer different questions. Cash tells you what you can spend. Revenue tells you how much of your promised work you have finished.

Take a customer who pays $24,000 on October 1 for a twelve-month subscription:

• On October 1 you have $24,000 more cash, but you have delivered nothing yet. That cash still counts in full toward your total assets, the figure behind the cheaper way to compute Delaware franchise tax.
• On October 31 you have delivered one of twelve months, so one twelfth of the price has been earned.
• On September 30 of the following year, all twelve months are delivered and the liability is gone.

If you booked the whole $24,000 as revenue on day one, your first month would look wildly profitable and your next eleven would look like you had no customers. That is why GAAP does not allow it, and why any investor reading your financials will look for the deferred revenue line.

The journal entries

You need three entries. Here is the sequence for the $24,000 example.

1. Invoice the customer. If you send the invoice before payment arrives, you record a receivable and a matching liability:

Some companies wait and only record the invoice once cash arrives. Either approach can be acceptable, but the balance sheet is cleaner if you record the invoice when it is issued and the contract is enforceable. In a state where you collect sales tax on SaaS, the tax on the invoice goes to its own liability account and never into deferred revenue.

2. Collect the cash.

3. Recognize one month of revenue, every month.

Repeat the third entry for twelve months. After the last one, deferred revenue for this customer is $0.00 and you have recognized $24,000 of revenue.

A worked example: three customers, one quarter

Real companies have many contracts starting on different days. Here are three, with a quarter-end balance sheet built from them.

All three pay in full on their start date. Here is what your books show at December 31.

Your bank account received $72,000 in the quarter. Your income statement shows $11,000 of revenue. The remaining $61,000 is a liability on the balance sheet that will turn into revenue over the next nine to eleven months.

A founder who reads only the bank balance thinks the quarter brought in $72,000. A founder who reads only revenue thinks it brought in $11,000. Both numbers are true. They measure different things, and you need both.

Current versus non-current deferred revenue

Balance sheets separate what will be resolved within twelve months (current) from what will take longer (non-current). Deferred revenue follows the same rule.

If a customer prepays $60,000 for a three-year contract at $20,000 per year, at signing:

Most seed and Series A companies sell mostly annual contracts, so nearly all of their deferred revenue is current. Multi-year prepay is where the split matters. It also affects a metric investors like: a large current deferred revenue balance means a lot of revenue is already contracted and paid for.

Common mistakes

Recognizing on invoice date. Sending an invoice is not delivering the service. Revenue follows delivery, not billing.

Confusing bookings, billings and revenue. Bookings are what customers commit to, billings are what you invoice, and revenue is what you have delivered. Deferred revenue is the gap between billings and revenue that has not closed yet.

Ignoring refunds and cancellations. If a contract lets the customer cancel for a refund of the unused term, the unearned portion is still a liability you may owe in cash. Read your contract terms and say so to your accountant.

Treating setup fees carelessly. A one-time onboarding fee is not automatically revenue on day one. Under ASC 606, if the fee does not give the customer a service of its own, it is usually recognized over the term of the subscription. This depends on the facts of the contract, so ask a professional when the fee is large.

Counting sales tax as revenue. Sales tax you collect from customers is a liability to a state, not revenue and not deferred revenue.

Mixing up monthly-billed customers. A customer who pays month to month has no deferred revenue, because you bill the month you deliver it. Deferred revenue mostly comes from annual and multi-year prepay.

What investors and auditors check

When you raise a round or sell the company, diligence teams tie your revenue to your billing and your deferred revenue to your contracts.

• Rollforward. Opening deferred revenue plus billings, less revenue recognized, equals closing deferred revenue. If your rollforward does not tie, expect questions.
• Contract sampling. They pick a few contracts, read the term and price, and check that your schedule matches.
• Cash-basis surprises. Companies that recorded cash as revenue have to restate, which is slow, expensive and easy to avoid by keeping accrual books before the first prepaid contract.
• Growth quality. A rising deferred revenue balance signals that customers are paying ahead, which supports the story that your revenue is recurring.

A spreadsheet works for the first ten or twenty contracts. It starts to break when you have mid-month starts, upgrades, credits and multi-year terms. Software that generates the recognition schedule from each contract removes that manual step. Which plan includes it varies a lot by product: Puzzle and QuickBooks Online put revenue recognition on very different tiers. LedgerIt keeps revenue schedules for annual plans paid up front, so the deferred revenue balance releases month by month and ties to your billing.

What to do this month

1. List every customer who paid more than one month in advance, with start date, term and amount.
2. Compute monthly revenue for each: total price divided by months in the term.
3. Check that your balance sheet has a deferred revenue liability and that it is not zero.
4. Post a monthly entry that moves each contract's share from deferred revenue to revenue.
5. Split multi-year prepay into current and non-current.
6. Build the rollforward: opening balance, plus billings, less revenue recognized, equals closing balance. Make sure it ties to your general ledger.
7. Ask your accountant to review how you treat setup fees, refunds and mid-term upgrades.

This article is general information, not accounting advice. Your contracts decide your treatment, so have a qualified accountant confirm it.