You gotta love signing that first big contract. It's often the result of a lot of hard work, and a laser-like focus from the founders.
But once that contract is signed, an important issue arises for many startups - when do you show that expected revenue in your financials?
This is where deferred revenue comes in.
Before digging into that, let's back up and go over the distinction between cash basis of accounting and accrual basis of accounting.
The cash basis of accounting is pretty much what it sounds like. Whenever cash enters or leaves your account, that's when you report the activity as it relates to your income statement and balance sheet.
On the other hand, the accrual basis focuses on when the actual activity that relates to the deposit or withdrawal from your account took place.
Here's an example to help illustrate this:
Suppose you offer a subscription to your software at $1,000 per month. Now assume a customer pays you $12,000 for a 12 month subscription.
According to cash basis, the revenue would all be recognized in the current month in which you received that $12,000 deposit.
Under the accrual basis, you would record $1,000 each month for this 12 month period to reflect how much you actually earned each period.
It's common for small companies who don't raise outside capital to use the cash basis, because it's a very simple way of recording what exactly is happening in the business. And again, all that it consists of is understanding what money is leaving your account and what money is entering your account at any given time.
The accrual basis is a lot more common for startups. Specifically to help investors understand what exactly is happening with the company.
What is the company earning in terms of revenue?
What is the company burning in terms of expenses (items that they are incurring as an expense)?
Now let's go back to deferred revenue.
Deferred revenue consists of the unearned revenue portion of an agreement with a customer.
Going back to our subscription example, when a customer pays you $12,000, or even if you invoice the customer for $12,000, it starts off as all deferred revenue. It has not yet been earned.
As each month progresses, you'll recognize another month's worth of revenue and reduce your deferred revenue balance. It's also important to note that deferred revenue is a balance sheet item. It'll show up on your balance sheet, which differs from your income statement, which would show the actual revenue.
Here's how it would look:
You have a $12,000 invoice that takes place in the current month.
Your actual revenue will show you're earning $1,000 each month, and your deferred revenue balance slowly reduces until it eventually hits zero, at the end of that 12 month period.
We've created a template that we feel is the best way to apply this waterfall. As illustrated below, the dynamic formula in the spreadsheet analyzes how much you have in sales for this month, and then using the "Length (months)", it will amortize that information accordingly.
If we change this 12 month annual sales to quarterly sales by changing the "Length (months)" cell to 3, then all of the corresponding information updates accordingly.
In addition, your deferred revenue starts off and gradually reduces each month by the amount that you specified.
The illustration above shows the calculation used to achieve this.
Your deferred revenue is comprised of the beginning balance, which equals last month's
balance, plus any new sales, minus any revenue tied to those sales.
That is what will flow through to your balance sheet and eventually onto your cash flows. For example, the cash flow statement the first month will show a positive $11,000 this amount was invoiced and collected, with $1,000 going towards revenue.
This template makes it really easy for you to enter information in any sort of cadence that you want - quarterly, semiannual, annual. Whatever works best for your startup.
It also allows you to play out different scenarios to see what sort of effect that would have on your income statement, balance sheet, and cash flows. For example, the below illustration shows how $15,000 of quarterly sales gets recognized over a three month period, allowing you to understand how the deferred revenue will play out into the future.
Deferred revenue helps provide insight into what is actually happening in a business, and how the products/services your startup is providing matches to the revenue being received.
Feel free to download the template and see what deferred revenue scenario works best for your startup.
Josh Aharonoff CEO and Outsourced CFO for startups
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