Is Deferred Revenue a Profit or a Pitfall for Your Business?

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This year has seen its share of ups and downs for automotive giant Tesla. Early in the year, CEO Elon Musk told investors he expected the business to be profitable in Q1. The following month, he announced the company would have to close many of its retail stores in order to sell the Model 3 with a $35,000 price tag.

The first half of the year continued to be problematic, and the business recorded a $689 million operating loss after Q2.

Then Tesla made headlines once again around the same time its Q3 earnings were reported—this time, for sitting on a half-billion dollars in deferred revenue.

Is this a good thing or a bad thing, though? What exactly is deferred revenue and what does this number mean for businesses like Tesla?

What is deferred revenue?

Deferred revenue is payment that has been received for goods or services before they’ve been fully delivered. Subscription businesses work with deferred revenue day-in and day-out because they collect payments for goods or services in advance of providing them.

For example, Disney+ was just released to the public, giving subscribers access to all things Disney-related for $6.99 a month. A customer pays that fee at the beginning of the month before he can even start the first movie or show. However, Disney+ cannot consider that payment as income just yet.

Because of the stringent ASC 606 revenue recognition standard, businesses are required to divide that money into two different pots: earned revenue and deferred revenue—also known as unearned or unrecognized revenue.

 

On that first day, only 1/30 of that $6.99 can be considered earned revenue, while the balance is considered deferred revenue. Each day the customer has access to Mickey Mouse, another thirtieth of that payment shifts from the deferred revenue pot to the earned revenue one.

At the end of the 30-day billing period, the entire $6.99 that was provided at the beginning of the payment period is now considered earned revenue.

Is deferred revenue a liability?

While collecting payment in advance of providing a service is a standard business practice in the subscription world, it’s important to note that deferred revenue is considered a liability, not an asset. This is because the business still ‘owes’ the customer the service.

Businesses that use the subscription billing model have the additional pressure to keep their customers happy by providing an excellent service at a competitive price, backed by knowledgeable customer care.

But let’s say a customer is dissatisfied with the service being provided and decides to cancel halfway through the billing period. There are two different options a business can exercise:

  1. Elect not to refund the payment but keep the subscription and access to the service active until the time when it would automatically renew. Commonly with a monthly subscription, a business will say, “Okay, we’ll cancel your subscription after this period. Feel free to use our services through the rest of the subscription period.”
  2. Refund the unused portion of the payment. This option is used more with annual versus monthly subscriptions.

A business that elects to refund the revenue that’s been deferred will need to issue a credit. This can get tricky if using a legacy billing system because the manual steps are prone to errors. Recurring billing software, on the other hand, can make these changes accurately, seamlessly, and automatically.

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When deferred revenue may be beneficial

So if deferred revenue is considered a liability, why do businesses elect to follow this business model?

When scaling, businesses can use deferred revenue to grow or expand their offerings, enabling them to use the pre-payments to fund growth initiatives. For example, if a business has $100,000 in deferred revenue sitting in the bank, it may opt to use that instead of taking out a large loan. Loans, after all, impact a business’s credit and may make them less attractive to investors.

This practice may be more practical for particular businesses.

A business that’s using deferred revenue to make capital investments can run into trouble. For example, if you’re using unearned income to build a manufacturing facility that in turn will create widgets customers have already purchased ahead of time, what happens if customers decide to cancel their orders?

Another concern is when a business is sold: what happens to the deferred revenue?

Although deferred revenue is considered a liability, accountants say it needs to be recognized as income as soon as the sale is complete.

As accounting and consulting service provider CitronCooperman suggests, “While there is a current benefit to deferring revenue, immediately upon the sale of assets, these advanced payments are required to be recognized as income. This acceleration will occur regardless of whether the products have been delivered or services performed, potentially creating an unexpected tax burden.”

Making sense of Tesla’s deferred revenue

One of the reasons Tesla has such impressive (or alarming) deferred revenue numbers is because many customers prepaid for the company’s ‘autonomy package,’ also known as ‘full self-driving’. In fact, prepaid orders go back as far as 2016.

Customers who purchased this package have received the onboard computer and all the required hardware already built into their Tesla vehicles. To date, the software to run this feature is still in development, but when it’s ready, the software will be installed over the air—essentially beamed into the already-installed vehicular operating systems.

Although the end of year is fast approaching, Musk’s quarterly earnings call in October had him characteristically optimistic about the rollout of the software, stating that “While it's going to be tight, it still does appear that we will be . . . in early access release of a feature complete self-driving feature this year.”

High deferred revenue rates are in other businesses too

It’s important to note while a half-billion dollars in deferred revenue almost seems mind-boggling, the practice isn’t exclusive to the automotive giant.

For example, in 2019 Apple reported it had $8.1 billion in deferred revenue, which is actually down from $8.8 billion in 2018. As contracts mature though, the tech titan said it expects to be able to recognize 68% of that deferred revenue over the next year.

Amazon Web Services has also had deferred revenue rates in the nosebleed section. In 2018, the company reported in one quarterly filing to the SEC that it had $12.4 billion in deferred revenue it planned to turn to recognized revenue over the course of several years. This is because it’s working through contracts that are primarily related to Amazon Web Services.

Is Tesla’s ‘cookie jar’ a concern?

The fact that Tesla is sitting on around half a billion dollars in deferred revenue is making a lot of investors and observers nervous.

Prior to the Q3 earnings release, AB Bernstein’s senior technology research analyst, Toni Sacconaghi, wrote about what he considered Tesla’s ‘Autopilot cookie jar’.

“Today, Tesla defers about $2,000 to $3,000 in revenues per car sold at time of sale—roughly half can be ascribed to Autopilot/FSD, and half to free/discounted Supercharging, free internet connectivity and future OTA software updates. In contrast to most of Tesla’s deferred revenue, which rolls off fairly predictably, recognition of deferred Autopilot/FSD revenue can be very non-linear: every time new Autopilot functionality is added, Tesla will draw down incremental deferred revenues for what it believes to be the value of the new functionality.”

Still, when that deferred revenue transitions to recognized revenue, it has a tremendous impact on the bottom line. Tesla posted a profitable Q3, partially due to lower operating expenses since its Model 3 production started. Also of note, its profitability is partially credited to moving deferred revenue tied to its Smart Summon related product to earned income.

Deferred revenue is commonplace to many SaaS and other subscription-based, recurring revenue businesses. Accurately tracking revenue recognition is essential to determine the health of your business, now and in the future.

When a business is scaling, it can be too easy to treat unrecognized revenue as ‘cash in hand’, but your business is responsible for upholding your terms in an agreement with customers by delivering the services as soon as they’re available.

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Tags: Recurring Billing Subscription Management Recurring Revenue Deferred Revenue

Mark Cerullo

Director of Product, Fusebill. Mark has spent the past 15 years working in high volume SaaS industry leading teams in sales, marketing, and product. Mark’s expertise includes driving companies into higher growth sectors for profitability, increased revenue, and acquisitions combined with a strong focus on customer experience.

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