What is Deferred Revenue?

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Definition:

Deferred revenue – aka unearned revenue – is money that a company receives in good faith from customers before they actually deliver the paid for goods or services.

🤔 Understanding deferred revenue

Deferred revenue is a future financial obligation of a company to a customer since it has received prepayment for yet-undelivered goods or services. Deferred revenue must be recorded as a liability on a company’s balance sheet because in accrual accounting – mandated by generally accepted accounting principles (GAAP) – revenue cannot be recognized until a company provides the goods or services it promised. As the company starts fulfilling the services or delivering the goods, the firm begins to “earn” the revenue, meaning that it can gradually start recognizing that revenue on its income statement. This is common for subscription-based companies where a customer may pay an upfront annual amount for a service that is delivered bit by bit each month. Once a company satisfactorily delivers all of the promised goods or services, then it is able to shift the entirety of the deferred revenue from its balance sheet to recognized revenue on its income statement).

Example

Let’s say you own a coffee cart in the central business district and charge $2 for a cup of hot java. Every Monday, a busy lawyer gives you $10 as prepayment for five cups of coffee during that workweek. This $10 is deferred revenue because you haven’t yet provided any coffee and now owe the lawyer those five cups.

On Monday, you can recognize $2 in revenue on your income statement for the first cup of coffee because you’ve made good on the promise and earned it. The deferred revenue on the balance sheet is now $8 because you still owe the lawyer four cups of coffee to complete your obligation. On Tuesday, you can realize another $2 in revenue for the second cup of coffee – Now, you owe three final cups for a total of $6. If things go smoothly, by Friday you’ve handed over five cups of coffee to the lawyer and cleared your obligation to her. The initial $10 in deferred revenue on the balance sheet has now all moved over to $10 of recognized revenue on the income statement.

Takeaway

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.

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What is deferred revenue?

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.

What types of businesses use deferred revenue?

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.

Example of deferred revenue in the publishing industry

Let’s take a look at the deferred revenue on the balance sheet of education publisher John Wiley & Sons, Inc. (Wiley) for the quarter that ended on Oct. 31, 2019.

The publisher listed its deferred revenue under contract liabilities for a total of $248.7M and noted that “contract liabilities are recognized as revenue when, or as, control of the products or services are transferred to the customer, and all revenue recognition criteria have been met.” Simply put, Wiley doesn’t recognize revenue on its income statement until the company actually delivers what they promised to the customer – Until then, it is a liability in the form of deferred revenue on the balance sheet.

In the same quarter, Wiley recognized $184.6M in revenue on the income statement that was previously deferred revenue. To prepare for any potential returns from customers, Wiley also kept $37.7M in contract liabilities designated specifically for that purpose.

(Source: John Wiley & Sons, Inc., Form 10-Q for the quarterly period that ended Oct. 31, 2019)

Example of deferred revenue in the tech industry

Now, let’s take a look at the deferred revenue on Salesforce’s balance sheet for the fiscal year that ended Jan. 31, 2020.

Salesforce is a software as a service (SaaS) provider that delivers many enterprise solutions, including a customer relationship management (CRM) system. Companies can outsource those responsibilities to Salesforce for a fee instead of having to heavily invest in building something themselves.

Salesforce charges its clients upfront subscription fees for services that it will deliver over time – typically over a period of three years or longer. Clients are generally willing to pay upfront because they get a discount for this advance payment.

As a result, most of the revenue that Salesforce reports each quarter comes from the recognition of deferred revenue related to subscriptions signed during previous quarters.

As of Jan. 31, 2020, Salesforce had $2.3B in deferred revenue (aka unearned revenue) on its balance sheet.

(Source: salesforce.com, inc., Form 10-K for the fiscal year ended Jan. 31, 2020)

How does deferred revenue work?

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.

How is deferred revenue recorded on the balance sheet?

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.

What is the difference between deferred revenue, unearned revenue, and accrued revenue?

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.

What is a deferred revenue expenditure?

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.

What are the tax rules for deferred revenue?

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.
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New customers need to sign up, get approved, and link their bank account. The cash value of the stock rewards may not be withdrawn for 30 days after the reward is claimed. Stock rewards not claimed within 60 days may expire. See full terms and conditions at rbnhd.co/freestock. Securities trading is offered through Robinhood Financial LLC.

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This information is educational, and is not an offer to sell or a solicitation of an offer to buy any security. This information is not a recommendation to buy, hold, or sell an investment or financial product, or take any action. This information is neither individualized nor a research report, and must not serve as the basis for any investment decision. All investments involve risk, including the possible loss of capital. Past performance does not guarantee future results or returns. Before making decisions with legal, tax, or accounting effects, you should consult appropriate professionals. Information is from sources deemed reliable on the date of publication, but Robinhood does not guarantee its accuracy.

Robinhood Financial LLC (member SIPC), is a registered broker dealer. Robinhood Securities, LLC (member SIPC), provides brokerage clearing services. Robinhood Crypto, LLC provides crypto currency trading. All are subsidiaries of Robinhood Markets, Inc. (‘Robinhood’).

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© 2022 Robinhood. All rights reserved.