Contract Liability vs Deferred Revenue: Accounting and Management

Contract liability and deferred revenue are two financial concepts that are often confused with each other.

Contract liability refers to the amount of money that a company owes to its customers or vendors as a result of a contract. This can include advance payments, deposits, or other forms of prepaid revenue.

Understanding the difference between contract liability and deferred revenue is crucial for accurate financial reporting and management.

A company's contract liability is typically recorded as a liability on its balance sheet, whereas deferred revenue is recorded as a current asset.

A contract asset arises when an entity has done work for a customer that has been recognized as revenue to date but has not yet issued an invoice or received payment for that work.

This is a common scenario in many industries, where a company provides services or goods to a customer, but hasn't yet sent an invoice or received payment. For example, a contractor might complete a project but not issue an invoice until the end of the month.

A contract asset is essentially the entity's right to consideration in exchange for goods or services that have been transferred to a customer, but the right is conditioned on something other than the passage of time.

Here's a simple way to remember the difference between a contract asset and a contract liability: a contract asset is like a promise of payment that hasn't been fulfilled yet, while a contract liability is like a promise of payment that has already been received but not yet fulfilled.

A contract asset arises when an entity has done work for a customer that has been recognized as revenue to date but has not yet issued an invoice or received payment for that work.

This means that a contract asset is essentially a promise of future payment, and it's not the same as trade receivables, which arise when an invoice has been issued.

Contract liabilities, on the other hand, arise when an entity has invoiced the customer or received payment from them but has not yet done the work.

To calculate the contract asset, you need to subtract the amounts invoiced to date from the revenue recognized to date.

Here's a simple example:

Revenue recognized to date: $X

Less: Amounts invoiced to date: ($X)

Contract asset/(liability): $X/($X)

Note that costs incurred to fulfill a contract should be expensed to the statement of profit or loss as they are incurred, unless they relate to future performance obligations, in which case they would be recognized as a contract asset.

It's worth noting that contract assets and liabilities are not the same as deferred revenue, although they may be referred to using similar terminology.

Let's dive into some examples of deferred revenue in action. A customer pays $1,200 for a yearly SaaS subscription in January, and by the end of the month, $100 becomes earned revenue, with the remaining $1,100 noted as deferred revenue.

In another example, a SaaS business signs a new customer for a year-long subscription, charging them a $100 initial set-up fee and $100 per month for a single product, totaling $1,300. However, they offer a 10% discount, bringing the total amount paid to $1,170, and at the end of January, the deferred revenue total would be $990.

Deferred revenue is a common occurrence in subscription-based businesses, and it's essential to record it as a liability, representing products or services owed to customers.

Tesla has a massive deferred revenue liability, which is around $2 billion. This is because customers have prepaid for the company's 'autonomy package', also known as 'full self-driving', as far back as 2016.

Customers who purchased this package have received the onboard computer and hardware, but the software is still in development and will be installed over the air. This raises questions about delivery and whether Tesla can meet its previous timeline projections.

Tesla's deferred revenue is mainly due to the prepayment for Autopilot/FSD, which accounts for roughly half of the deferred revenue per car sold. The other half is attributed to free/discounted Supercharging, free internet connectivity, and future OTA software updates.

The deferred revenue is a concern for investors and observers, as it can be non-linear and unpredictable. This is because new Autopilot functionality is added, drawing down incremental deferred revenues for the value of the new functionality.

Tesla became profitable in 2020 and has continued to report profits since, with $12.5 billion in profits in 2022. However, the large amount of deferred revenue on the books raises questions about the company's ability to deliver on its promises.

In Example Subscription #2, a one-year $12,000 subscription has an order date of April 1, 2013, a subscription start date and revenue start date of April 15, 2013, and a subscription end date and revenue end date of April 14, 2014. This subscription is invoiced quarterly starting on April 15, 2013.

The revenue is recognized monthly, with $1,000 recognized each month, just like in Example Subscription #1. However, the Deferred Revenue Balance as of the End of the Period is different because the revenue is not recognized in full at the beginning of the subscription.

The Revenue Backlog remains the same as in Example Subscription #1, because it's not affected by invoices. But the Deferred Revenue Balance decreases as the revenue is recognized each month, resulting in a lower balance by the end of the period.

By the end of the first quarter, the Deferred Revenue Balance as of the End of the Period is $9,000, which is $3,000 less than the initial invoiced amount. This is because $3,000 in revenue has been recognized and earned.

Tracking and managing contract assets is a crucial part of financial management, especially when it comes to accounting for deferred revenue.

Contract assets arise when an entity has done work for a customer that has been recognized as revenue to date but has not yet issued an invoice or received payment for that work.

To accurately track contract assets, it's essential to identify them as distinct from trade receivables, which will arise when an invoice has been issued. This distinction is crucial for financial modeling and ensuring accuracy in financial statements.

Mosaic, a financial management tool, streamlines tracking deferred revenue by singling out specific accounts labeled as "deferred revenue accounts." This allows the tool to accurately slot deferred revenue into the right boxes across the platform.

By using Mosaic's data mapping feature, you can ensure that your contract assets are accurately accounted for and presented in your balance sheet.

Let's start with some accounting terminology that's essential to understand.

Generally accepted accounting principles (GAAP) require businesses to account for revenue when it's earned, and expenses when they're incurred.

Revenue is considered earned when it's received, but there are cases where payment is received before goods or services are fully delivered, known as deferred revenue.

Deferred revenue is payment received for goods or services before they've been fully delivered, like rent payments or retainers.

One example of deferred revenue is a subscription service like Disney+, where customers pay a monthly fee upfront for access to content.

Disney+ can't consider the entire payment as income just yet, because the customer hasn't received the full benefit of the service.

The ASC 606 revenue recognition standard requires businesses to divide payments into two pots: earned revenue and deferred revenue.

For example, on the first day of a 30-day billing period, only 1/30 of the payment is considered earned revenue, while the balance is deferred revenue.

As the customer accesses more content, another portion of the payment shifts from deferred revenue to earned revenue.

Accurately tracking deferred revenue is crucial for SaaS businesses to get a clear snapshot of their financial obligations and fiscal health.

This accurate representation of fiscal health helps businesses forecast and understand future cash flow, gaining insight into renewal rates and customer churn based on deferred revenue.

Accurately tracking deferred revenue also proves a company's ability to obtain long-term business from customers, earning investors' trust.

By tracking liabilities, businesses can manage their obligation to deliver services in the future, ensuring they don't overcommit or overspend.

A clearer understanding of net income is also gained when tracking deferred revenue accurately.

Here are the key benefits of accurately tracking deferred revenue:

The return of contract liability is a crucial concept to understand when dealing with contract accounting. It's a way to recognize revenue that's earned but not yet received.

Contract liability is typically recorded when a customer pays for a service or product upfront, but the work hasn't been completed yet. In this case, the company has a contractual obligation to deliver the goods or services.

Companies like Apple and Microsoft often use contract liability to account for pre-paid software subscriptions. This means they recognize revenue over time as the customer uses the service.

For example, if a customer pays $100 upfront for a one-year software subscription, Apple would record $8.33 in revenue each month as the customer uses the service.