What Is Deferred Revenue?
Deferred revenue is also known as unearned revenue. The term refers to advance payments a company receives for products or services. These are to be delivered or performed in the future. The company that receives the prepayment records the amount as deferred revenue. It is recorded as a liability on its balance sheet.
Even though it has the word revenue in it, unearned revenue is a liability. This is because it represents the goods or services you owe to your customers. Just because money is in your bank account, it doesn’t mean your client won’t cancel or ask for a refund. So, deferred revenue is a liability because it reflects revenue that has not been earned. Therefore, it represents products or services that are still owed to a customer. As time passes, and the product or service is delivered, it is recognized proportionally as revenue on the income statement.
- Liability – Deferred revenue is a liability on a company’s balance sheet. This is because it represents a prepayment for goods or services that have yet to be delivered.
- Recognized Only Once it’s Earned – Deferred revenue is recognized as earned revenue on the income statement only when the good or service is delivered to the customer.
- GAAP Accounting Guidelines – The use of the deferred revenue account follows GAAP guidelines for accounting conservatism.
- Subject to Refunds and Cancellations – If the good or service is not delivered as planned, the company may owe the money back to its customer.
How Deferred Revenue Works
Deferred revenue is recorded as a liability on the balance sheet of a company that receives an advance payment. This is because it has an obligation to the customer in the form of the products or services owed. The payment is considered a liability to the company because there is still the possibility that the good or service may not be delivered, or the buyer might cancel the order.
In either case, the company would need to repay the customer, unless other payment terms were explicitly stated in a signed contract. Contracts can stipulate different terms, whereby it’s possible that no revenue may be recorded until all of the services or products have been delivered. In other words, the payments collected from the customer would remain in deferred revenue until the customer has received in full what was due according to the contract. (Source:investopedia)
Accounting for Deferred Revenue
Generally accepted accounting principles (GAAP) require methods and conventions that encourage conservatism. Accounting conservatism ensures the company is reporting the lowest possible profit. A company reporting revenue conservatively will only recognize earned revenue. This occurs when it has completed the required tasks to have full claim to the money. Income is recognized only once the likelihood of payment is certain.
As a company delivers services or products, deferred revenue is gradually recognized on the income statement. However, only to the extent that the revenue is earned. It may be tempting to categorize deferred revenue as earned revenue too quickly. Or, simply bypassing the deferral altogether and posting it directly to revenue on the income statement. However, this is considered aggressive accounting and effectively overstates sales revenue.
Deferred revenue is typically reported as a current liability on a company’s balance sheet. This is because prepayment terms are typically for 12 months or less. However, customers can make up-front prepayments for services that are expected to be delivered over several years. The portion of the payment that pertains to services to be provided after 12 months is considered long term. Respectively, they should be classified as deferred revenue under the long-term liability section of the balance sheet.
Revenue Recognition Principle
Why can’t you just record the revenue when you receive the money? Well, the revenue recognition principle states you should only record revenue that is not only realized but earned. Even though you have cash in hand as a deposit or advance payment, you haven’t earned it yet. It only becomes earned once the goods or services are provided to the customer. Until it’s earned, the money received is a liability because it signifies an obligation to the customer. Knowing how to deal with deferred revenue properly is a very big part of the accounting for subscription businesses.
How does Deferred Revenue work under Cash vs Accrual Accounting?
- Cash Basis Accounting – If your business uses the cash basis of accounting, you don’t have to worry about deferred revenue. According to cash basis accounting, you “earn” revenue the moment a payment hits your bank account, end of the story.
- Accrual Basis Accounting – Under accrual basis accounting, you record revenue only after it’s been earned. When accountants talk about “revenue recognition,” they’re referring to how deferred revenue gets turned into earned revenue.
Example of Deferred Revenue
Deferred revenue is common with subscription-based products or services that require prepayments. Examples of unearned revenue are rent payments received in advance, prepayment received for newspaper subscriptions, annual prepayment received for the use of software, and prepaid insurance.
For example, on Jan 1, VirusScan Co receives a $1,200 payment for a one-year contract from a new client. Since the services are to be expensed over a year, the company must take the revenue and divide it into monthly amounts of $100.
- January 1 – the company would record revenue of $0 on the income statement. On the balance sheet, cash would increase by $1,200 and a liability called deferred revenue of $1,200 would be created.
- February 1 – the company would record revenue of $100 on the income statement. On the balance sheet, cash would be unaffected and the deferred revenue liability would reduce to $1,100 while net income of $100 would be added to retained earnings in shareholders’ equity.
- This pattern repeats – the pattern of recognizing $100 in revenue repeats each month until the end of 12 months. Year-end, total revenue recognized over the period is $1,200. Retained earnings are $1,200 and cash is $1,200. At that point, the deferred revenue from the transaction is now $0.
What about the Paying Company?
The other company involved in a prepayment situation would record their advance cash outlay as a prepaid expense, an asset account, on their balance sheet. The other company recognizes its prepaid amount as an expense over a period of time at the same rate as the first company recognizes earned revenue. Consider a media company that receives $1,200 in advance payment at the beginning of its fiscal year from a customer for an annual newspaper subscription. Upon receipt of the payment, the company’s accountant records a debit entry to the cash and cash equivalent account and a credit entry to the deferred revenue account for $1,200.
As the fiscal year progresses, the company sends the newspaper to its customer each month and recognizes revenue. Monthly, the accountant records a debit entry to the deferred revenue account, and a credit entry to the sales revenue account for $100. By the end of the fiscal year, the entire deferred revenue balance of $1,200 has been gradually booked as revenue on the income statement at the rate of $100 per month. The balance is now $0 in the deferred revenue account until next year’s prepayment is made. (Source:investopedia)
What Kinds of Businesses Deal with Deferred Revenue?
Any business that collects fees from customers in advance will carry unearned revenue on its books. Common examples include:
- Professionals who collect retainers (lawyers, consultants, developers)
- Airlines and hotels
- Concert and sports ticketing services
- Cleaning and housekeeping services
- Businesses that collect rent
- Prepaid insurance
- Businesses that charge subscription fees (magazines, SaaS companies, meal delivery services)
- Businesses that charge membership fees (professional associations, private clubs, gyms)
- Contractors that charge an up-front deposit
Why is Deferred Revenue Seen as a Liability?
- Your money isn’t realized You still owe your customers the required service or goods. These should be provided for the completed transaction. So it cannot be counted as revenue just because it shows in your bank records. If your customer wishes to terminate the service before the unfulfilled period of subscription, you’ll need to return the sum for that period. For example, if they terminate the subscription after 5 months, the money should be returned for the remaining 7 months.
- Prevents business over-valuation It is easy to factor in growth based on the money that hits your bank before the promised service has been delivered. This muddies your company’s forecasting methods and creates the illusion of growth. You can mistakenly believe you’ve grown and started investing the unrecognized balance to keep the growth momentum. Your investors can mistakenly believe that you’re growing when the reality is something different.
- Multiple services offered Some businesses offer multiple services along with their subscription model. For example, annual maintenance for two years. In this case, one part of the service you’re providing is fulfilled at purchase. But, the other needs to be deferred. This will show that one part of your revenue is earned and another unearned. This leads to complex accounting issues as there are multiple stages of delivery. Realizing these revenues too early can lead to false positives showing up in your cash-flow statements. Therefore, it is important to track your contract terms with your customers before realizing the revenue.
Why Does Deferred Revenue Matter?
Deferred revenue is important for accurate reporting of assets and liabilities on a company’s balance sheet. It protects against treating unearned income as an asset. It also guards against overvaluing the company’s net worth. While cash is usually the safest asset a company owns, not all cash is equal. Cash that is classified as deferred revenues is at risk until the work is performed. Nevertheless, deferred revenues are important to a company. They can finance growth and operations without encumbering other company assets or taking on debt.
Frequently Asked Questions
Can you spend deferred revenue the same way you spend regular cash?
Cash from unearned revenues probably sits in your bank account just like cash from earned revenues, the two are not the same. If you don’t deliver the agreed-upon good or service, or your customer is unhappy with the end product, your deferred revenues could be at risk. Generally speaking, you should be more careful in spending cash from deferred revenues than regular cash.
Is Deferred Revenue good or bad?
Although deferred revenue is a liability, having lots of it on your books isn’t necessarily a bad thing. Just as long as you’re able to deliver the goods and services you promised them. In that case, it’s generally better to get financing from your customers in the form of deferred revenue. It beats taking out a line of credit from a bank.
How do you separate unearned income from your company’s cash flows?
Deferred revenue means that your company’s revenue and its cash flow will be recorded in different periods. The cash flow is recorded immediately, while revenues are recorded once the revenue is earned. If you collect lots of deferred revenue, low cash flow this month doesn’t necessarily mean low revenues and vice versa.
Deferred Revenue Final Words
Up Next: What is Margin Trading – Margin Investing – Buying Stocks on Margin?
Margin is money borrowed from a brokerage firm to purchase an investment. It is called margin as it is the marginal value between the securities held in an investor’s account and the loan amount from the broker. Margin Trading is the act of borrowing money to buy securities. The practice includes buying an asset where the buyer pays only a percentage of the asset’s value and borrows the rest from the bank or broker. The broker acts as a lender and the securities in the investor’s account is held as collateral.
The word margin has several meanings, not only in the world of business and finance but in other situations as well. It can refer to the difference between the cost of a product and how much you sell it for. Or, it can mean the amount by which revenue from total sales exceeds costs in a business. Margin can also refer to the portion of the interest rate on an adjustable-rate mortgage (ARM) added to the adjustment-index rate.