Accounting question on Deferred Revenue
Am i thinking about deferred revenue correctly?
Let's say Im a SaaS biz that books $100 of business at start of year in January. Im thinking in terms of accounting impacts, nothing should happen to I/S as by the revenue recognition and matching principles, revenue needs to be matched to expenses and cannot be reported until it is earned. Since I have not delivered any product and I have also not incurred expenses related to the distribution to the client, nothing should change on my I/S with this new booking. On the B/S, cash on Assets side is up by $100 and deferred revenue on Liabilities side is up by $100, so B/S balances. I believe that the +$100 of deferred revenue has to be accounted on the CF statement somewhere to flow into B/S cash, but not exactly sure how to account for it... Maybe change in CF from operations, as a result of an increase in current liabilities (deferred revenue)?
Onboarding takes 3 mo,, and after the first quarter, I finally recognize $12 of the revenue that was deferred. On I/S, revenue is up $12 but offset by an increase in lets say $2 in COGS. So pretax profit up by $10 and assuming 30% tax rate, NI is up $7. On CFS, Ni is up $7 but need to take into account recognition of deferred revenue of $12 (current liability) and the decrease of $10 in inventory (current asset) so net change in cash is +$5. On B/S, cash is up $5 on assets side, inventory falls by $10 so net change is -$5 on assets side. On Liabilities & Equity side, deferred revenue -$12 and retained earnings +$7 so -$5 and B/S balances.
Does this look right? Would really appreciate any help here!
bump
Yes. From your first paragraph, you are correct in your understanding of deferred revenue. In GAAP accounting, a company recognizes revenue when it performs its service. When it receives cash in advance, the company still needs to perform the service for the cash received. Since it owes that customer service, the company marks the cash received as a current liability through deferred revenue.
I'm going to walk through both parts of your scenario given the information you outlined. I'm assuming $2 COGS, 30% marginal tax rate, and $100 received initially.
When the company receives $100 cash in advance, the journal entry is a debit for cash for $100 and a credit to deferred revenue for $100. There is no change to I/S. In CFS, the CFO section would go up by $100 because of the $100 increase in current liabilities from deferred revenue. Remember, the major line items of CFO are net income, changes in net working capital(look at increases and decreases in current assets and liabilities), and gains and losses.
When current asset accounts like accounts receivable increase, the company doesn't receive that cash even though it's recognized as revenue, Therefore, increases in current assets decrease CFO and decreases in current assets increase CFO. It's the opposite for current liabilities because the company is effectively accruing more cash. Since a current liability like deferred revenue goes up by $100, CFO is up by $100. There's no other cash changes, so net cash is up by $100. On B/S, cash is up by $100, and deferred revenue is up by $100. Cash is an asset, and deferred revenue is a liability. So assets are up by $100 and liabilities are up by $100. Therefore, we are balanced.
Now for the second part of the problem, we need to use fractional reasoning. If the $100 was paid up front(the deferred revenue) for the entire year, we assume that every month 100/12 of that cash converts into revenue. For a whole quarter(assuming no adjusting entries are made before then), we would do 3/12 * 100= $25. So the corresponding journal entry is a debit to deferred revenue of $25 and a credit to revenue for $25. When the inventory is sold, you debit COGS for $2 and credit inventory for $2.
On I/S, pre-tax income goes up by $23(25-2). At a 30% marginal tax rate, net income goes up by $16.10. In the CFS, net income flows into CFO. We also need to account for the decrease in current asset of inventory. CFO goes up by $16.10 + $2 or $18.10. No other areas impacted on CFS, so net cash is up by $18.10. On balance sheet, cash is up by $18.10 and inventory is down by $2. Assets are up by $16.10. Retained earnings, which is a SE account, is up by $16.10 since the net income flows into it. Since assets and SE are both up by $16.10, we are balanced.
Hope this helps
wonderful and developed response, thank you! Is it common to recognize the deferred revenue on a monthly basis? My thinking is that if it takes 3 months to onboard the customer, then you cant recognize the revenue till onboarding has finished and client has received the service offered. Hence why I started recognizing at start of Q2
Depends on how the company handles adjusting entries. If they do it every month, then revenue would be recognized every month as (deferred revenue/12). If it is done at the end of each quarter, then you'd have to multiply deferred revenue by 1/4. As for your second question, it really depends on the type of service. Since you talked about inventory, I assumed the company was operating on contracted streams of revenue like a magazine subscription or phone service. It depends on the business model, but in general deferred revenue is usually allocated as an equal portion over each month. That is, assuming the up front payment was for a yearly service. If it's only for 3 months for example, then each month revenue would be recognized at (deferred revenue/3).
Hope this helps
I believe this is incorrect. I'll explain why; however, I also do not know the correct answer if we start considering costs/expenses.
When the business receives the $100 cash associated with deferred revenue, it must pay $30 in cash taxes to the IRS, even when book/GAAP accounting has no changes to the income statement as no revenue has been earned/recognized. This creates a $30 DTA.
Income Statement: No changes Cash Flow: +$100 deferred revenue (increase in liability / decrease in operating WC is a source of cash), -$30 due to creation of a DTA (asset going up is a use of cash). Net cash +$70. Balance Sheet: +$70 Cash +30 DTA, so Assets up $100. Liabilities up $100 as well due to +$100 deferred revenue. No change to equity.
Later on, when revenue has been recognized, we unwind the DTA. Income Statement: Revenue +$100, pay $30 taxes, net income up $70. Cash Flow: +$70 net income, -$100 deferred revenue (reduction in liability / increase in operating WC is a use of cash), +$30 due to DTA unwind (asset going down is source of cash). Net cash is 0. Balance Sheet: No change in cash. DTA down by 30, so assets down $30. Liabilities down by $100 due to deferred revenue down by $100. To balance, shareholder's equity increases by $70, which matches with the $70 increase to net income on the Income Statement.
The issue is that by accrual accounting, we apply matching principle. So upon recognition of revenue, we must also record the expenses/costs associated with earning that revenue. Assuming $20 of expenses (all COGS) we'd effectively reduce the amount of taxes on Income Statement. However, the issue is that now we'd have a different DTA figure to unwind.
Income Statement: Revenue +$100. Record $20 COGS expense. Pay $30% x 80 pre-tax income = $24 in taxes. Result in $56 net income. Cash Flow: +$56 net income. Inventory has fallen due to COGS expense so source of cash +$20. +$24 source of cash from unwinding DTA. -$100 due to conversion of deferred revenue into earned revenue. Net cash (+56+20+24-100 = 0). Balance Sheet: Cash 0. -$24 DTA. -$20 inventory. Net change in assets is -$44. On liabilities side, deferred revenue -$100. Shareholder's equity up $56.
Had you just straight up earned revenue and recorded it (not via recording deferred revenue and then converting it later), you would have had: Income Statement: +$100 revenue $20 cogs => pre-tax $80. Pay $24 taxes. NI up $56. Cash Flow: NI +$56. Inventory unwind +$20. Cash +76. Balance Sheet: Cash +$76. Inventory -$20. Assets up $56, shareholder's equity up $56.
So the same ending result in terms of +$56 shareholder's equity, except you have an extra $6 of DTA ($20 COGS * 30% tax rate not factored into cash taxes initially paid) sitting on the balance sheet from discrepancies between cash vs. book accounting principles in the creation and unwind of the DTA due to deferred revenue. That is, you had paid $6 extra in cash taxes earlier, although at this point I'm not sure if this DTA carries forward like a NOL or must be written down.
How do zou arrive at the inventory figures, do saas companies have inventory
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