What is deferred revenue?

What is deferred revenue?

Deferred revenue is money received from an advance payment of goods or services. Common examples of deferred revenue include memberships or subscription-based services paid upfront, annual subscriptions for software paid in one lump sum at the start of a contract (think payments to SaaS companies—or Software as a Service businesses), or prepayments for custom orders that won’t be delivered until they’re built. 

In all of these cases, the customer has paid the seller or business owner without receiving the goods or services they paid for, in part or in full. As the goods and services are provided, the associated revenue can be recognized in the form of a debit from the deferred revenue account and a credit to earned revenue.

For accrual accounting purposes, it’s critical to understand that deferred revenue is a liability until it’s recognized as earned revenue because the seller is still on the hook to deliver a good or service. If the seller is unable to meet their obligations in accordance with the sale, they may have to hand that money back to the buyer (cash-basis accounting, which records revenue and expenses only as money is paid out or received, does not recognize deferred revenue).

Note that deferred revenue does not appear on the income statement because the revenue is not yet recognized as income; however, it does appear on the cash flow statement, because it represents an incoming cash payment.

How deferred revenue works

Deferred revenue is created when a customer pays in advance for goods or services, which means it can’t be recognized yet, according to Generally Accepted Accounting Principles (GAAP) revenue recognition principles. Here’s a snapshot of how that works in practice:

Step 1: An advance payment is received. A customer makes an upfront payment for a good or service. For instance, a software company with a SaaS business model receives $120,000 for a one-year subscription. The software will be delivered over the next twelve months, so the lump-sum payment can’t be fully recognized yet.

Step 2: Deferred revenue is recorded as a liability. Upon receiving the cash payment, the business records $120,000 on the balance sheet as deferred revenue or unearned income. The accounting journal entry would look like this:

Debit: Cash $120,000 (to show that the payment was received)

Credit: Deferred revenue $120,000 (reflecting the payment as a liability)

Step 3: Revenue is earned over time as goods and services are delivered. As the software is delivered over the duration of the contract, the company providing the software can recognize revenue. In our example, the company would recognize $10,000 every month for a year. The accounting journal entry would look like this:

Debit: Deferred revenue $10,000

Credit: Earned revenue $10,000

Step 4: Liability is fully settled once the contract is fulfilled. After one year, all of the revenue has been recognized as earned and debited from the deferred revenue balance (the liability account).

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Why is deferred revenue important in accounting?

Similar to financial reporting metrics like gross profit margin and current ratio, deferred revenue helps to paint a picture of a company’s overall financial health. In particular, it lends insight into a business’s liabilities and potential for logging earned revenue in the future. It’s important in accounting for a number of reasons:

• Accurate revenue recognition: Listing upfront payments as deferred rather than earned revenue ensures that companies are not overstating earnings by recognizing revenue before it’s truly been earned—which is when the money no longer carries an obligation to provide a good or service in the future.
• Compliance: GAAP and International Financial Reporting Standards (IFRS) are designed to ensure that companies report earnings conservatively, and that they report the lowest possible profit. Deferred revenue is a critical component of these conservative accounting standards because it ensures companies are not masking liabilities as earnings, which could mislead investors, lenders, regulators, and other potential stakeholders.
• Financial health: Deferred revenue serves as an indicator for both current liabilities and future income, so it can help markets accurately assess a company’s valuation, potential future cash flow, and financial trajectory.

Deferred revenue vs. accrued revenue

Deferred revenue and accrued revenue are both essential accounting concepts that appear on financial statements, but they mean different things. Whereas deferred revenue is a liability representing money earned from a prepaid expense (for the promise of goods or services to be delivered later), accrued revenue is an asset representing money that will be earned in the future for goods and services that have already been provided.

Deferred revenue:

• Is listed as a liability on the balance sheet
• Represents future revenue that can only be recognized once goods or services have been provided (for example, prepayment for a piece of equipment that hasn’t been delivered yet, or an upfront payment for an annual membership)
• Is recognized over time as the good or service is provided

Accrued revenue:

• Is listed as an asset on the balance sheet
• Represents goods or services that have already been delivered, but for which payment has not yet been received (for example, a consulting project that’s complete but awaiting payment)
• Is recognized, but not yet realized—meaning the cash hasn’t been received

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What type of liability is deferred revenue?

For any accounting period, deferred revenue can be classified as either a current liability or a long-term liability depending on when the products or services are expected to be delivered.

• Current liability: Deferred revenue is logged as a current liability on the balance sheet if it reflects a short-term obligation due within a year. That could be, for example, a prepaid annual subscription for a newspaper or software tool, or upfront rent payments on a one-year lease.
• Long-term liability: If delivery of the product or service extends beyond a year, then deferred revenue is recorded as a long-term liability on the balance sheet. This could be for a multi-year software or service contact paid upfront, for instance.

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