Deferred Revenue – How to Handle it and How it Affects Your Business
We missed on revenue… our cash flows are strapped… we’re really at risk on this. None of these are phrases a CEO or business owner wants to hear. When they do hear them, it very well could be a result of deferred revenue issues coming to the surface. Here, we take a look at what deferred revenue is, how it affects your business, and how to effectively manage it.
What is Deferred Revenue?
Deferred revenue refers to payments received by a company for products or services ahead of those products or services being completely delivered. Deferred revenue is booked on the balance sheet as a liability because the business still owes that product or service to the customer. The deferred revenue liability is reduced on an amortized basis or per contractual terms as the income is earned and then reflected on the income statement as revenue.
Businesses that regularly contend with deferred revenue include subscription- or license-based businesses (like SaaS organizations or content streaming services), construction, professional services, or property management firms issuing rental agreements. Here’s a fictional example:
When the outer building frames of an entertainment center chain’s forthcoming locations are complete, ACME Services is hired by the chain to ready the interior of the buildings for business. They are paid an average of $1M upfront for each location, book that invoice as deferred revenue, and then recognize the revenue based on the completion of milestones that are spelled out in the contract using the percentage of completion method.
In this example, if ACME Services immediately booked the $1M prepayment as income or recognized portions of it as income before contractual obligations were met, it would be equivalent to counting their chickens before they hatch. Some degree of risk is present because the customer could potentially back out and demand a refund for the remaining dollars, or unforeseen circumstances could delay the completion of the work. An additional issue common in subscription-based businesses is counting on repeat business at the end of a cycle, even though customers may elect not to renew a contract. This may be a smaller issue when revenue is well distributed and the company isn’t reliant on few customers but is a bigger issue for planning and projections otherwise.
What Happens When Deferred Revenue Isn’t Handled Properly?
Mishandling deferred revenue translates to an incomplete or inaccurate view of the company’s financial state. Cash flow liabilities and areas such as customer acquisition cost, financial projections, and staffing plans can be impacted. For example, if revenue is overstated or prepayments are delayed, the company may be compelled to implement alternative measures to address the cashflow challenges. Overstating or misrepresenting financial statements poses significant risks, leading to potential legal and financial consequences. Additionally, such actions can undermine the confidence of both the leadership team and the broader market in the company.
Common Mistakes in Handling Deferred Revenue and How to Address Them
A wide array of variables can lead to mistakes and inaccuracies in how deferred revenue is handled, including:
- Inability to discern details in customer contracts or improperly interpreting clauses, terms, and conditions within them
- Misalignment of when revenue is truly earned versus when it is recorded on the income statement
- Inability of the company to meet obligations per contractual agreements or customer expectations
- Misalignment between when a sale closes and when a customer is invoiced
The good news is that the variables noted above are addressable. As the points suggest, deferred revenue isn’t just an accounting issue. Handling deferred revenue properly and doing everything possible to make sure that it becomes actual revenue requires cooperation and contribution across the business.
Maintain a Deferred Revenue Dialogue
Dialogue about deferred revenue is crucial and comes in many forms. It’s talking with sales to clarify billing period details, engaging with engineering to understand technical complexities about risks that could impact delivery, or conferring with legal to check contractual interpretations. Deferred revenue dialogue is also about ensuring alignment across the leadership team regarding cash flow projections, agreeing on where risks involving deferred revenue may lie, and how best to mitigate the risks and cash flow concerns. These internal conversations could involve:
- Emphasizing securing longer-term contracts to elongate revenue streams and avoid having to quickly jump back into renewal conversations
- Assessing whether the right amortization schedules are in place
- Reviewing forecasts and the profile of customers the company is currently doing business with
- Use of deferred revenue – ensuring there is agreement in the company when part of the deferred revenue is used to fund other strategic projects
Dialogue with customers to ensure their satisfaction, uncover issues, and build strong relationships is also key. All customer-facing roles need to be able to have constructive and candid conversations with customers to ensure concerns are raised quickly in both directions. Finance and accounting need to be part of the discussions to ensure they can generate the correct financials and can provide the correct guidance to the management team.
Another important element of dialogue can come via audits. While some may shudder at the thought of audits, an audit team can actually be a helpful sounding board for business decisions related to deferred revenue. Audits can discover previously unseen issues and instill confidence in the company’s strategy.
One important team member that can navigate Deferred Revenue concerns is an experienced fractional CFO who would look at the business lifecycle from start to finish – cost of sales, revenue fluctuations, gross margins, audit reports and concerns memos, Board minutes, pricing structures, amortization schedules, and more to surface issues and implement solutions.
Confidence and Continuous Improvement
A disciplined best-practices approach to handling deferred revenue arms your leadership team with the information and context it needs to make smart longer-term decisions. Company leaders should have a clear understanding of what deferred revenue is, how it impacts the business, and factors that can cause deferred revenue issues to rear their ugly head.
A company should be deliberate about creating and maintaining a dialogue regarding deferred revenue in its business. The goals of this dialogue are to closely monitor what’s happening operationally, recognize risks proactively, align on the best strategy, and apply lessons learned. Doing so will promote a culture of confidence and set the stage for continuous improvement.
How much does deferred revenue impact your business? How much would you benefit from handling deferred revenue better? Request a Free Consultation with a proven CFO who has deep experience in surfacing and remedying issues related to deferred revenue. We’ve partnered with more than 5,000 businesses in our 28 years and are ready to put our expertise and experience to work for you.