If you’re in the business world, chances are you’ve heard of deferred revenue. It’s a common accounting term that refers to money that has been earned but not yet received. For example, if you sell a product on credit, the sale is considered deferred revenue until the customer pays their bill. As such, it’s important to know how to forecast deferred revenue accurately.
So how do you go about forecasting your company’s deferred revenue? In this guide, we’ll take into account various factors and show you how to forecast deferred revenue the right way.
How to Forecast Deferred Revenue
There are a few different methods that can be used to forecast deferred revenue. One common method is to look at historical patterns and try to extrapolate future trends.
This can be done using regression analysis or other forecasting techniques. Another approach is to build a model that predicts deferred revenue based on other factors that are known to affect it, such as sales volume or customer churn.
What is Deferred Revenue?
Deferred revenue is money that hasn’t been earned yet.
In accrual accounting, only income that has actually been received is counted.
If a customer pays for a good or service before it’s provided, then the company does not report any revenue on its balance sheet. Rather, it reports a liability.
The financial statement is key to both accounting and modeling.
Example of Deferred Revenue
Let’s look at an example of the accounting entries that are made when companies create and then reverse or earn their deferred revenue.
XYZ cloud solutions received a $1,200 payment from a new client for a one-year contract. Since the service will be rendered monthly, XYZ will book the $100 in monthly payments.
The $1,200 payment from the customer would not be recorded on the company’s income statement. Instead, a liability called deferred revenue would appear on the balance sheet.
By the end of the first month, the $100 will be recorded in the financial statement. The $100 in deferred revenue liability would also be reduced.
The pattern would be recognized each month for 12 consecutive months. By the end of the one-year contract, this will result in $1,200 in annual revenue, $1,200 in net cash flow, and $1,200 in retained earnings.
At this point, the deferred revenue is now $0.
Why Companies Record Deferred Revenue
The short answer is that companies are required to recognize revenue when a sale is made.
In accrual accounting, deferred revenue is a liability. This is because the company has to owe either the cash or goods/services that have been paid for.
Many companies choose to record the revenue from their sales when it is actually received, as opposed to when it is made. This allows them to more accurately represent their earnings and cash flow.
Cash from Operating Activities
Now we’ll take a look at how these changes affect the cash flows.
Referring to the previous example, the company had $0 in net earnings at the start of the contract. At the same time, there was an increase of $1,200 in its current liability. This caused its cash flow from operations to be $1,200 as well.
In the subsequent months, each $100 in additional income will be offset by a $100 reduction in the current liability (the deferred revenue account).
How to Forecast Deferred Revenue?
If you are preparing a financial plan for your business, you will have to project your expected deferred revenue.
To forecast deferred revenue, you will need to take into account three financial statements:
- Profit-and-loss: revenue over time-based on the billing cycle
- Balance sheet: revenue whenever a new customer purchases a subscription
- Cash flow: cash as soon as payment is made.
Deferred revenue is fairly straightforward to forecast for SaaS companies, but it gets a little more complicated when trying to include it in these three financial statements.
To forecast deferred revenue, businesses need to take into account multiple subscription tiers with different billing cycles, as well as upsells, downgrades, and churn.
Conclusion
How to forecast deferred revenue can be a tricky task, but it’s important to get it right. By taking into account various factors and using the tips in this guide, you can create an accurate forecast that will help you make sound financial decisions.
