If you have a business where you collect money upfront from customers, like a magazine subscription or an annual software license or some other type of annual service paid upfront, then you probably have to face the issue of estimating the deferred revenue liability on your balance sheet.

Deferred revenues, that sounds like some accounting jargon.  What that means is you have to match your revenues with the period that you earned the revenues in.  A 12 month magazine subscription is earned one month at a time.  So, if somebody subscribed to your magazine in July, they would still have six months remaining at the end of the year and your deferred revenue liability for that customer would be half a year’s subscription of 50% of the total subscription price received.  If you offer multi-year plans, you can see that the liability is even more significant.

So, this is a pretty important number to be estimating on the balance sheet.  For some companies, it can be the largest liability that they have on the books.  However, don’t feel bad for them.  In their model, they’re getting cash upfront from the customers and then paying to deliver the service later. 

In the magazine example, it’s pretty easy to see for just that one cast that the numbers should be 50% of the revenues received.  However, now, suppose you have thousands or tens of thousands of customers or you have a wide variety of different plans.  For example, I have a health information client that has some very large contracts and some not so large and a wide range of different subscription services.  The question comes now when you’re doing a projection.  What should the deferred revenue liability be that you happen to project?  It’s a number that often does not get enough thought and can have a very big swing on the results.

For example, if your revenues come in evenly throughout the year, then the deferred revenues liability should be about half of your annual deferred revenues that you collect.  Some customers may only have one month left, but others may have eleven, for example.

The tendency can be to swag it, or scientific wild ass guess, and use a number like 25%, but that falls well short of a 50% number that you would expect to be the average number.  If your estimate in your financial model of your deferred revenue is less than 50%, you probably need to ask some questions and determine if that really makes sense.  It could, if you have some non subscription based types of revenues or you happen to get a lot of your renewals right towards the start of the New Year. 

But, for many cases, that number should be around 50% of the total revenue and if it’s much less you could be prematurely recognizing some income.  Take another example.  Suppose you have a growing company.  Now, it’s gets even worse.  Suppose your revenues in the second half of the year have grown to be twice what your revenues were in the first half of the year.  Your deferred revenue liability is going to be heavily weighted toward the end of the year and you could very likely have a number that’s closer to nine months of revenue than six months.  In theory, the only time you should have a smaller number, like three months or less, would be where your renewals are very heavy upfront and you’ve had a history of years under your belt.

Deferred revenues are a very important item that can be the most significant liability on the balance sheet.  Make sure you handle it with care and get yourself an outside opinion based upon the extra transactions you had in the past.  Get the deferred revenues right and you can be assured you have a good handle on your numbers and not get surprised at some point in time down the road.