What is Deferred Revenue?

Deferred revenue is kind of like a signing bonus...

When you score a new job, your employer might give you a signing bonus to sweeten the deal. However, before you start, you haven’t actually done anything to earn that money. Because of this, employers might have a clause in your contract that mandates you to repay that signing bonus if you, say, quit prior to having worked there for six months. This signing bonus is similar to deferred revenue – You have an obligation to fulfill for the company before fully “earning” that money. By the end of the six months, you’ve earned your keep and the entirety of your signing bonus is now recognized revenue – You can spend the cash on whatever you want without risk of losing it.

When a company accepts customer prepayment for the future delivery of goods or services, it is recorded as deferred revenue. According to accrual accounting – mandated by the generally accepted accounting principles (GAAP) that most organizations use – a company must record deferred revenue on its balance sheet as a liability. This is often marked down as a contract liability because the company becomes contractually bound to deliver the goods or services when it accepts the customer’s advance payment.

As the company fulfills its contract by carrying out the services or providing the goods, it can start recognizing the deferred revenue as revenue on its income statement – a financial snapshot highlighting how much profit a company generates over a set period of time.

Deferred revenue may turn into income on the income statement either all at once (e.g., delivering all of the widgets to a client in one delivery) or gradually (e.g., mailing a magazine monthly over the span of a one-year subscription). Several factors, including the types of goods or services and contract terms, affect how deferred revenue turns into income.

Any business that collects prepayment for goods and/or services will tend to use deferred revenue in its accounting. Examples of businesses that may use deferred revenue include:

• Professional services: Many service-based industries, including consulting, architecture, engineering, law, and marketing may require an upfront payment to secure delivery of services.
• Hospitality companies: Companies like hotels, catering companies, airlines, concert halls, and travel agencies may receive prepayment for bookings or events that have not yet occurred.
• Landlords: Landlords, owners of real estate properties, and third-party real estate management companies may receive prepayment for part or all of a lease term from a tenant.
• Insurers: Providers of insurance services – like auto, home, and life – may receive upfront payment for an insurance policy. For example, a policyholder may pay upfront for six months or a year at a time.
• Subscription services: This includes companies that charge membership fees or dues prior to delivering goods (e.g., subscription boxes, magazines, meal deliveries) and/or services (e.g., gyms, cloud web hosting, and other software as a service (SaaS) providers).

Any company that requires an advanced payment from its customers and then owes the good or service likely records deferred revenue in its accounting.

Deferred revenue affects three key financial statements – the balance sheet, income statement, and cash flow statement. Let’s use a fictitious example to take a closer look at how deferred revenue works.

On Jan.1, suppose that an architecture firm receives an advanced payment of $120,000 for a one-year contract of its design services. On that day, four accounting events take place:

• Balance sheet: An entry for $120,000 of cash is debited (i.e. recorded) to the asset section of the balance sheet for the money received.
• Balance sheet: A liability called contractual liability, or deferred or unearned revenue, is credited to the balance sheet to record the services that the architecture firm now owes.
• Income statement: No revenue or income is recorded on the income statement on Jan. 1 because the company hasn’t performed any of its design services yet.
• Cash flow statement: An entry appears for incoming cash of $120,000.

By Feb. 1, the company has completed a full month of design services and may now recognize $10,000 in revenue for work completed in January. On that day, four accounting events take place:

• Balance sheet: Deferred revenue decreases by $10,000 to $110,000.
• Balance sheet: Cash is unaffected since the company received prepayment for the design services and no new money exchanged hands.
• Income statement: Recognized revenue increases by $10,000.
• Cash flow statement: Cash flow from operations is unaffected since the company received prepayment for the design services and no new money exchanged hands.

This process would repeat every month for the rest of the year. By the end of the year, the company would have recognized all $120,000 as revenue on the income statement and decreased the deferred revenue liability on the balance sheet to $0.

Assuming all else stays the same, here’s the full annual overview of the total balances of cash, deferred revenue, and revenue for the architecture firm.

A company records deferred revenue on its balance sheet as a liability. It is typically referred to as a contractual liability, deferred revenue, or unearned revenue because the company hasn’t yet earned that money and still owes the goods or services to the customer.

There are two key types of deferred revenue, depending on how long it takes a company to provide the goods or services. If a company performs the services or delivers the goods within 12 months, deferred revenue is recorded as a current liability – This means that the financial obligation is due within a year. When the fulfillment of the contract takes longer than 12 months, then a company records this deferred revenue as a long-term liability on its balance sheet.

Deferred revenue may also be split between the two categories if it is expected to be steadily earned over more than a year.

For example, suppose you have a three-year contract where you will earn the same portion of revenue each month for the next three years. In this case, one-third of the money would be recorded as a current liability since it will occur within the first 12 months. The other two-thirds would be listed under long-term liabilities since this revenue wouldn’t land until the second and third years.

Deferred revenue is typically a good thing as long as you’re able to deliver the goods and services that you owe your customers. Unlike other liabilities, deferred revenue that keeps on growing is a positive sign for your business. Increasing deferred revenue means that your business is collecting advanced payments from clients.

To start, there is no difference between deferred revenue and unearned revenue. They’re synonyms and often used interchangeably.

However, there is a difference between deferred revenue and accrued revenue and it is based on the timing of the customer’s payment.

When the customer pays you upfront and you provide the goods or services later, it’s known as deferred revenue. When you provide the goods or services upfront and the client both hasn’t been billed yet and pays you later, it’s called accrued revenue. This appears on the balance sheet. But if you’ve already sent an invoice, it would be recorded under accounts receivable on the balance sheet.

Unlike deferred revenue, a deferred revenue expenditure – aka deferred expense – is an asset on the balance sheet. A deferred expense is a long-term prepaid expense, which means that the company has paid in advance for goods or services that it will receive over a time period longer than 12 months. A regular prepaid expense, however, is a short-term prepayment for a good or service fully used within 12 months.

An example of a prepaid expense is a three-month advertising contract that a company paid for upfront, while an example of a deferred revenue expenditure is a prepaid two-year office lease.

The Internal Revenue Service (IRS) allows business owners to use the cash accounting or accrual accounting method to calculate their taxable income.

If a company uses the cash accounting method, then deferred revenue is irrelevant — the company pays income taxes as it receives payments no matter what. However, companies that use the accrual accounting method – required by the generally accepted accounting principles (GAAP) that most large corporations use – are able to defer income taxes to a later date once they’ve actually “earned” the revenue by making good on their promises, as we’ve discussed.

The companies need to keep track of the difference between taxable and non-taxable income, according to IRS rules. According to the accounting rules:

• If the accounting value of income tax is greater than the income tax on a company’s tax return: The company records this difference as deferred income tax as a liability on its balance sheet.
• If the accounting value of income tax is equal to the income tax on a company’s tax return: The company doesn’t take any action as there is no difference between the two values.
• If the accounting value of income tax is less than the income tax on a company’s tax return: The company records this difference as prepaid income tax as an asset on its balance sheet.