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To protect their interests, many companies require their customers and clients to pay upfront for products or services before they are delivered.
Since this type of revenue is not immediately recognized, it is known as deferred revenue. Often seen in subscription-based businesses and online services, deferred revenue is income collected before the service is provided.
What is Deferred Revenue?
In accrual accounting, deferred revenue is income that has been collected but not yet earned.
According to the revenue recognition principle, companies must recognize revenue when it is earned (i.e., when a good or service is delivered), not necessarily when cash has been received.
Because of this, companies record deferred revenue as current liabilities on their balance sheets until the services are rendered or products are delivered.
Deferred revenue is a popular concept among both businesses and customers.
For companies, deferred revenue gives them access to funds upfront while allowing them to recognize the income when it’s earned. This helps businesses maximize their cash flow by providing them with capital to finance operations without waiting for it to be earned.
It also enables them to guarantee future income, which can be helpful when forecasting revenue and making long-term strategic decisions.
From the customer’s perspective, deferred revenue provides them with certainty that they will receive the product or service they paid for. In some cases, it may also entitle them to a sales discount.
- Unearned Revenue: Payment for services or products that have not been delivered to the end customer.
- Deferred Income: Payment received in advance, but not yet recognized as income.
What is Deferred Revenue in SaaS?
In the Software-as-a-Service (SaaS) industry, deferred revenue is common practice—monthly and annual subscription payments are usually collected upfront to guarantee future income.
The SaaS industry has seen an influx of deferred revenue in recent years due to the proliferation of the subscription business model and services requiring pre-payment.
In SaaS, collecting payment upfront is often the best option for both the company and the customer—it gives customers the assurance that they will receive the product or service they paid for and provides the company with capital to finance operations in advance.
And in the event of a policy dispute regarding refunds or cancellations, the money is already in the company’s account. This helps companies protect themselves from customers who may take advantage of the “try before you buy” model.
What is Deferred Revenue in Retail?
In retail, customers typically buy products at the same time they use them.
Retail transactions generally involve an immediate exchange of value, meaning that the customer pays for their purchase at the time of the sale. However, some retail transactions involve deferred revenue.
There are two common examples of deferred revenue in retail:
- Online Pre-Orders: Customers can pre-order a product before its release date, and the company collects payment upfront. Pre-orders are common in the gaming, fashion, and entertainment industries. In entertainment, for example, companies need to sell tickets to upcoming events before they take place. Otherwise, they risk not selling out.
- Gift Cards: Companies issue gift cards to customers who can later redeem them for goods or services. When customers redeem the gift cards, they receive their purchase in exchange for value already paid by the original customer.
In both of these cases, companies collect payment before delivery, meaning that their financial statements will show a deferred revenue balance.
Why Companies Record Deferred Revenue
There are several reasons companies record deferred revenue:
- Recording deferred revenues and expenses provides a more accurate financial picture by spreading out income earned over the life of a contract or service.
- From an operational standpoint, deferred revenue helps businesses plan ahead for their resource needs, allowing them to better manage personnel and budget resources.
- Deferred revenue allows businesses to maintain their liquidity and reduces the risk of cash flow problems, as it gives them a better sense of when to expect funds from their revenue streams.
- Organizations can access lines of credit or other sources of financing more easily, as sound financial planning and predictable revenue are required for banks and other lenders to provide these resources.
Deferred Revenue and Accrual Accounting
Accrual accounting is an accounting system that records revenues and expenses when earned or incurred, regardless of when payment is received or made.
This method of recording transactions is based on the concept of matching revenues and expenses to the same period to provide a more accurate view of a company’s financial performance.
There are three types of revenue in accrual accounting:
- Deferred Revenue: Deferred revenue is income that has been earned but not yet recognized as revenue in the financial statements.
- Accrued Revenue: Accrued revenue is revenue that has been earned but not yet received. This type of revenue is recorded at the end of an accounting period when the invoice is sent to customers.
- Recognized Revenue: Recognized revenue is revenue that has been both earned and received. This type of revenue is recorded when cash is received from the customer.
When companies record deferred revenues, they recognize a liability—an obligation to deliver goods or services in exchange for payment already received.
On the income statement, a deferred revenue liability is not recorded. Instead, it is left off until the goods or services are delivered.
The Difference Between Deferred and Recognized Revenue
According to ASC 606 and GAAP accounting standards, companies can only recognize revenue when it is realized or earned.
This means the customer must receive a product or service in exchange for payment before the revenue can be recognized and recorded on the income statement.
Deferred revenue is money a company receives before goods or services are delivered, which is why it is not recognized as revenue in the income statement.
According to these accounting principles, it is instead reported as a liability on the balance sheet until the goods or services are delivered, and the revenue can be recognized.
Deferred Revenue vs. Unearned Revenue
Deferred revenue and unearned revenue describe the same concept: money received from customers before goods or services are delivered.
While deferred revenue is recorded as a liability on the balance sheet, unearned income is simply an entry in a company’s general ledger.
In some cases, businesses may use both terms interchangeably. However, others may make a distinction between the two terms by referring to deferred revenue as money that has been received and unearned income as money that is expected but not yet received.
Short-Term Revenue vs. Deferred Revenue
Short-term revenue and deferred revenue represent distinct financial concepts that impact a company’s financial reporting and performance evaluation. Short-term revenue, also known as recognized or earned revenue, refers to the income generated by a company through its core business activities within a specific reporting period, typically within the next 12 months. It is recognized on the income statement when goods are delivered or services are provided to customers, indicating immediate financial inflow.
On the other hand, deferred revenue, or unearned revenue, represents payments received from customers in advance for goods or services that have not yet been delivered. It is recorded as a liability on the balance sheet until the company fulfills its obligations, at which point it is gradually recognized as revenue on the income statement. The distinction between these two concepts lies in the timing of revenue recognition: short-term revenue reflects current sales, while deferred revenue reflects future obligations and represents a company’s commitment to fulfilling its promises to customers over time.
Calculating and Recording Deferred Revenue
Calculating and recording deferred revenue works as follows:
- When a company receives an advance payment for goods or services, it must calculate the deferred revenue amount. To do this, the company would subtract the estimated cost of delivering goods or services from the total payments received.
- The resulting amount is then reported as a liability on the balance sheet.
- Once goods and services are delivered to customers, companies can recognize the deferred revenue on their income statement as recognized revenue.
- The amount of liability previously reported is then removed from the balance sheet and replaced with a corresponding accounting entry in the income statement. This ensures that the company’s financial statements remain accurate and up to date in the current accounting period.
Revenue Recognition Technology
This technology uses sophisticated algorithms to automate income recognition, eliminating manual data entry and helps ensure accuracy.
DealHub’s billing platform is an example of such technology.
Subscription management capabilities allow companies to accurately track deferred revenue and recognize revenue when goods or services are delivered.
This helps them comply with accounting standards while reducing their financial close time.
People Also Ask
What is the opposite of deferred revenue?
The opposite of deferred revenue is accrued revenue (i.e., revenue recognized before cash is received). The difference between the two is that deferred revenue is money a company receives before goods or services are delivered, while accrued revenue is money a company receives after goods or services are delivered.
Is deferred revenue an asset or expense?
When deferred revenue is recorded, it appears as a liability on the balance sheet and increases the cash (asset) account. Once the income is earned, the liability account decreases, and the revenue account sees an overall increase.
Why is deferred revenue a liability?
Deferred revenue is a liability because it represents a company’s obligation to deliver goods or services in exchange for payment. These payments are received before the revenue can be recognized and recorded on the income statement, so they must be reported as liabilities until goods or services are delivered.