(Note: this article originally appeared in slightly different form on the Lighter Capital blog and is republished with permission).
Is your business considering a move to accrual accounting? A key thing to understand is what deferred revenue is and how to accurately record it while following Generally Accepted Accounting Principles (GAAP).
Understanding how accrual accounting works can seem a little overwhelming and confusing. We’ll walk you through the basics to help you get started.
Cash versus accrual accounting
Cash accounting and accrual accounting are the two main ways you can approach your financials. One of the biggest distinctions between the two is at what time you recognize revenue.
Cash accounting offers the easiest way — you simply recognize the revenue at the time you receive the payment which can work for certain businesses. However, in some situations, cash accounting can lead to problems when the payment you receive does not come at the same time as the goods or services you provide. For example, you may sell a product or service and be waiting for payment, or you may receive payment for a subscription to a service that you provide over time. In both of these cases, it’s not possible to match income and expenses when you use cash accounting.
With accrual accounting, revenue can be recognized at one of three times:
- When cash is received (if the timing aligns with the goods or services provided);
- At the time that the goods or services are provided, even though the actual cash will not be received until some point in the future
- Spread out over future points in time in situations where payment is received upfront and the service is provided over time (this scenario is known as deferred revenue).
Although accrual accounting is more complicated, it allows you to recognize revenue at the time that enables you to best match cash income with the expenses incurred while generating that income.
Deferred revenue 101
Deferred revenue is the accounting strategy used in accrual accounting when you do not recognize revenue immediately upon receipt, but instead recognize that revenue over time. For example, SaaS businesses that are selling pre-paid subscriptions with services rendered over time will defer revenue over the life of the contract and use accrual accounting to demonstrate how the company is doing over the longer term.
This approach shifts the focus from large one-hit cash events (short-term excitement) to how much sales are contributing to long term growth and profitability. Basically you are trying to answer the first of many questions about the health of your business — Is the contract profitable compared to the ongoing support expenses over time?
According to GAAP, deferred revenue is a liability related to a revenue-producing activity for which revenue has not yet been recognized. Since you have already received upfront payments for future services, you will have future cash outflow to service the contract. Therefore, a company should record deferred revenue as a liability in the balance sheet when it receives payments from clients for products or services that have not yet been delivered or rendered.
How you should debit and credit deferred revenue
For example, let’s say a software company signs a three-year maintenance contract with a customer for $48,000 per year. The company gets paid $48,000 upfront on January 1st for the maintenance service for the entire year. On January 1st, when the company receives cash payments from the customer, the company will debit cash for $48,000 and credit (increase) the deferred revenue account for $48,000.
As each month passes and services are actually performed, the company should debit the deferred revenue account and post a credit to the revenue account. For instance, on February 1st, the company should recognize $4,000 as a credit in the revenue account ($48,000/12 = $4,000) and debit $4,000 in the deferred revenue account to show that services have been performed and revenue has been recognized for the period from January 1st to January 31st. The company’s cash account will not change.
This image shows how the process will pan out over the course of each year:
A common mistake
An error made by many entrepreneurs is to offset deferred revenue with accounts receivable. Some companies record the entire contract value in accounts receivable and deferred revenue to show the potential economic impact of future contracts on the present value of the business. This is not in accordance with GAAP. Deferred revenue should not be used as a double entry account along with accounts receivable to reveal contract values. Investors like Lighter Capital, venture capitalists, and angels will take contracts with customers into consideration when evaluating the value of the company, although your bank probably won’t do so.
Thanks again to Lighter Capital for sharing this article with inDinero’s audience! We both encourage all business owners to learn more about cash, accrual, and GAAP as they grow their business and its accounting.
Got more questions about implementing GAAP with your business? Download our checklist for getting GAAP-ready to see what switching to GAAP actually looks like.