When companies receive payments in advance for products or services they will provide to a customer in the future, they refer to this as deferred revenue, or sometimes unearned revenue. Under accounting rules used by most U.S. public companies, deferred revenue is a liability on the balance sheet because the company has already been paid and now has the obligation of providing services or goods.
What is deferred revenue and how is it calculated?
Deferred revenue refers to money a company receives for goods or services it has not yet delivered. Any transaction that is an upfront payment for services or goods to be delivered over time is an example of deferred revenue. Subscriptions for video services or magazines, memberships that require advance payment, rent, and even ticket sales for future events are examples of transactions that result in deferred revenue.
Take a private club that collects a $12,000 annual membership fee in advance. The club would credit $1,000 in sales immediately, counting the remainder as a liability. In each of the following 11 months it would recognize, or record, $1,000 as revenue. By the end of the year, the deferred revenue bookkeeping entry would be zero and the full $12,000 would be listed as revenue.
According to generally accepted accounting principles (GAAP), a set of rules and standards issued by the Financial Accounting Standards Board (FASB), public companies must record deferred revenue on the balance sheet, not the income statement. One goal of this is to prevent companies from overstating their sales. That means companies must use the accrual accounting method, which records revenue at the time of the transaction but does not count it as income until the service is provided.
In contrast, small and private companies sometimes use cash basis accounting, which counts money received at the time of payment as revenue.
Accrued revenue is different from deferred revenue. It refers to goods or services a company provides to a customer before being paid instead of receiving payment in advance. It is accounted for with a separate entry on the balance sheet until payment is received. Accrual accounting, which is used by most large or publicly traded companies, records revenue at the time of the transaction but does not count it as income until the service is provided.
How deferred revenue works in accounting
Deferred revenue is not considered income until it is earned. Rather, it is recorded as a liability on the balance sheet.
Although GAAP accounting requires that the accrual accounting method be used to avoid inflating sales, it allows for different types of revenue recognition. Some of the most common ones are:
- Percentage of completion. This is usually used when a contract spans multiple tax years, in which the company determines how much of the revenue the business has earned up to a certain point.
- Completed contract. This does not recognize any of the deferred revenue until the entire contract has been fulfilled.
- Sales basis. Recognition of revenue occurs at the same moment the sale takes place. It’s sometimes used by retailers.
- Cost recoverability. The seller doesn’t recognize any revenue until all the costs associated with finishing a project have been recovered.
Because each accounting method counts the deferred amount as revenue at a different stage, one company’s financial statements might differ from another’s based on the accounting method.
Why is deferred revenue a liability?
When a company has been paid money in advance for goods or services but hasn’t yet delivered them, the company technically hasn’t yet earned the revenue, so that money must be recorded as deferred under accrual accounting.
It is typically shown as a current liability on a company’s balance sheet for 12 months because prepayment usually covers a one-year term. If a customer made a multiple-year contract with a company and paid in advance, the total value of the contract would be counted as deferred revenue under the long-term liability section of the balance sheet.
Counting deferred revenue as a liability accomplishes several things including:
- Reflects real earnings. Revenue is technically not earned until the service is provided by the company, even if a customer already paid for it. Counting deferred revenue as a liability allows investors to see that. If deferred revenue were not counted as a liability, that could inflate the perceived value of a company and mislead investors.
- Allows for returns. If a customer pays upfront but decides to terminate their commitment early or return a good, they might have the right to a fund. Deferred revenue can be reduced on the balance sheet to reflect the return of money to the buyer.
- Shows multiple revenue streams. Many companies have hybrid structures, in which some revenue is deferred (such as membership or subscription services), while other purchases are fulfilled at the time of payment. Recording deferred revenue as a liability makes this clear.
Deferred revenue vs. deferred expense
Like deferred revenue, deferred expense is a transfer of money for something to be received in the future. The difference lies in who makes the payment.
Deferred revenue is the money a company receives from a customer in advance for products or services it will provide in the future. It records the revenue as a liability until it has delivered on its commitment, at which point it transfers the liability to the income statement as revenue or sales.
Deferred expense, also called prepaid expense, refers to the money a company has paid for a good or service it has not yet received. Deferred expense is recorded as an asset on the balance sheet. Rent payments in advance for a storefront or equipment are examples of a deferred expense. As the company uses the equipment or storefront or other prepaid goods or services over time, it transfers amounts incrementally from an asset line on the balance sheet to expenses on the income statement.
The bottom line
When companies receive payments in advance for services or goods they will provide in the future, that’s considered deferred revenue. Accounting rules require companies to count such payments as a liability on the balance sheet until the company delivers the services or goods. At that point, some or all of the liability is transferred to the income statement as revenue.
This method is used because it avoids inflating a company’s sales (and potentially its stock market valuation) before revenue is formally earned.