Unearned Revenue

Why Unearned Revenue Is Critical in SaaS

SaaS businesses center on unearned revenue. When a customer pays for a subscription service, they’re essentially making a prepayment. For example, say a customer pays you in January for an annual subscription. Since the year has yet to occur, they haven’t technically “received” what they’ve paid for. However, you will be delivering the service to them month by month in the form of access to your software.

According to accrual accounting, you can’t recognize all the money the customer has paid as revenue on your income statement until you’ve delivered the service, month by month. Below, we’ll explain how this works in practice.

But for now, let’s look at how unearned revenue can function as a key performance indicator in SaaS.

Track Renewals and Cash Flow

Simply put, to understand how your SaaS business will perform in the future, you need to keep tabs on unearned revenue today.

Since unearned revenue is closely related to cash flow, understanding it helps guide company strategy. Think of unearned revenue as a SaaS cash flow barometer. If you see your unearned revenue declining in the near future, you’ll know you may need to scale back expenses or look for other ways to boost short-term cash flow. If it’s increasing, you can afford to plan bigger reinvestments in your SaaS business and double down on the strategies that are keeping customer retention high and improving new customer acquisition.

Calculate Metrics

Proper recognition of unearned revenue is also crucial for financial reporting because it helps you accurately calculate some of the most important SaaS metrics.

For instance, without accounting for unearned revenue you won’t be able to properly determine your gross margin.

Boost Investor Confidence

You know who cares quite a bit about your ability to retain customers and hit certain benchmarks? Investors.

They also care about your ability to accurately present financials. And tracking unearned revenue can make all the difference in your VC or exit pitch.

Show investors you have a strong recurring revenue model, one that you truly understand by accounting for the ebb and flow of unearned revenue.

Why Unearned Revenue Is a Liability, Not an Asset

Typically, money in your accounts would be considered an asset on your balance sheet. But unearned revenue is a bit unusual. Because the service hasn’t been provided yet, unearned revenue counts as a liability in GAAP. Under accrual accounting, you only recognize revenue when you “earn” it. In this case, since you still owe the customer the service in question, you haven’t earned it!

But you do earn it over time as the subscription plan unfolds. Gradually, unearned revenue on the balance sheet will move over to subscription revenue on the income statement — it’s gone from being unearned, unrecognized revenue to recognized revenue.

To better understand why unearned revenue is a liability, not an asset, you can think of it as the opposite of an account receivable. For you, ARs are an asset because the customer owes you money. But, since unearned revenue means you owe the customer a service (and the costs involved with delivering that service), it’s a liability.

Since most SaaS contracts won’t go beyond a year, unearned revenue is usually recorded as a current liability on the balance sheet. If the service rendered does go beyond 12 months, it’d be recorded as a long-term liability.

How to Calculate and Recognize Unearned Revenue

In a subscription business, customers usually pay in advance for the entire length of the contract.

The unearned revenue calculation involves dividing that payment by the length of a customer’s subscription.

So, if someone signs an annual contract and pays $12,000 up-front, you’d divide $12,000 by 12. In this example, your monthly unearned revenue (from this single contract) would be $1,000 and $11,000 total. As your customer uses your service each month, $1,000 would move from unearned revenue into revenue.

Keep in mind that it’s not always this simple, even if you do offer annual contracts. Set-up fees, for example, could count as a separate line item on the contract (i.e., something else owed besides access to the software).

And that brings us to ASC 606, a set of rules introduced by the Financial Accounting Standards Board to help track unearned revenue through an accounting period.

ASC 606 provides the following framework for revenue recognition:

• Select the customer’s contract
• Identify the performance obligations within the contract
• Ascertain the transaction price
• Allocate the transaction price to the contracted performance obligations
• Recognize revenue at the time each performance obligation is fulfilled

In SaaS, the contract with your customer is the initial booking, upon which you invoice. Your “performance obligation” is to provide access to your software, which you do month by month to convert the cash received into earned revenue.

As this obligation is satisfied, you recognize revenue, moving it from your balance sheet to your income statement.

What about the cash flow statement? Even though, according to revenue recognition principles, you have not earned the customer’s subscription payment until the entire subscription period has elapsed, it’s still an injection of cash that you can use as you like — that means it gets recorded on the cash flow statement right away.

Examples of Unearned Revenue in SaaS

To make things a bit clearer, let’s look at some real-life examples of how you’d recognize unrecognized revenue in SaaS bookkeeping.

Example #1

Say you get a customer to sign up in April for a six-month subscription. $6,000 is the total contract value, making your monthly unearned revenue (from this contract) $1,000.

In April, you record the total contract value on your balance sheet by debiting cash or cash equivalents (an asset) for $6,000, while also crediting unearned revenue (a liability account) for $6,000.

Recognizing unearned revenue means transferring it from your balance sheet to your income statement. That means debiting unearned revenue, while crediting subscription revenue on your profit & loss.

So, in May, the unearned revenue from this contract decreases to $5,000, while on the income statement, subscription revenue increases by $1,000. In June, unearned revenue decreases to $4,000, while subscription revenue increases by another $1,000.

You repeat the process month by month, until 6 months have passed and the entire amount has been transferred and “earned”.

Example #2

In this example, a customer pays for an annual subscription to your product in January. Normally, the total contract value would be $12,000, but because they are paying for a year upfront, you offer a 10% discount, bringing it to $10,800. That makes your monthly unearned revenue $900 ($10,800/12) for this contract.

Fortunately, they like the product so much that, in March, they upgrade to a higher tier. This increases the subscription price by $250 each month. By March, you’ve already recognized two months’ worth of revenue from the contract — $1,800, bringing the original unearned revenue down to $9,000.

But now you have to add the upgrade value to that number. For 10 months remaining in the year, you add $2,500 (the price of the add-on, $250 a month, multiplied by 10) for a new total contract value of $11,500. Your new monthly unearned revenue from this contract is $1,150 ($11,500/10).

For the rest of the year, you’ll credit unearned revenue on the balance sheet for $1,150, until the total contract value of $13,300 ($10,800, the original value, plus $2,500, the amount paid for the add-on) has been listed as revenue on the income statement.

How to Track Unearned Revenue in Mosaic

Tracking unearned revenue is possibly one of the most important accounting tasks there is in a subscription-based business. By doing it right, you get an accurate picture of your financial situation and the strength of your bookings process (not to mention remaining in line with accounting standards).

That being said, it’s not always easy — especially if you’re relying on spreadsheets in Excel.

Mosaic helps make SaaS revenue recognition a breeze. Mosaic allows you to view the underlying customer details in your unearned revenue account, helping you properly track unearned revenue by customer.

Mosaic’s business logic automatically creates a metric in your instance called scheduled revenue. This metric automatically calculates the monthly revenue recognition per customer by looking at the contract start date and end date in conjunction with the total contract value. This helps finance teams automate the revenue recognition entries needed to adjust unearned revenue each month.

In addition, Mosaic’s Topline Planner has built-in waterfall functionality to help translate forecasted bookings into unearned revenue, cash collections, and billings.

Mosaic allows you to build a much more accurate model of your SaaS business’s trajectory. To see Mosaic in action, request a demo today.