Deferred revenue, also known as unearned revenue or revenue in advance, is a financial concept that relates to the recognition of revenue in accounting.
Deferred revenue occurs when a company receives payment from a customer but has not yet delivered the goods or services.
In this case, the payment is recognized as a liability on the company’s balance sheet until the goods or services are provided.
Once they are provided, the liability is converted into revenue and recognized on the company’s income statement.
Example of Deferred Revenue
For example, imagine a software company that sells annual subscriptions for its cloud-based service. A customer purchases a one-year subscription for $1,200 and pays the full amount upfront. However, the company recognizes revenue from this transaction on a monthly basis over the course of the subscription period.
Initially, the $1,200 received is recorded as deferred revenue on the balance sheet because the company has yet to provide the services. As each month passes, the company recognizes $100 of revenue, reflecting the proportionate amount of service delivered. By the end of the 12-month subscription period, the entire $1,200 will have been recognized as revenue, and the deferred revenue account will be reduced to zero.
How Deferred Revenue Works
Deferred revenue works by deferring the recognition of revenue until the performance obligations are met.
Here are the key steps involved in managing deferred revenue:
- Receipt of Payment: The company receives payment from customers for goods or services before providing them.
- Deferral of Revenue: The amount received is recorded as a liability on the balance sheet, typically under the category of deferred revenue or unearned revenue.
- Revenue Recognition: As the company fulfills its obligations and satisfies the performance criteria, revenue is recognized gradually over time or at specific milestones.
- Reduction of Deferred Revenue: With each recognized portion of revenue, the deferred revenue balance is reduced, while the corresponding amount is recorded as revenue in the income statement.
- Financial Reporting: The company discloses the deferred revenue balance and its changes over time in its financial statements to provide transparency to investors, stakeholders, and regulatory bodies.
Deferred Revenue FAQ
- Why is deferred revenue important?
Deferred revenue is important because it ensures accurate financial reporting by matching revenue with the delivery of goods or services. It helps companies avoid prematurely recognizing revenue and provides transparency regarding their financial obligations to customers. Deferred revenue accounts are reconciled as part of the month-end close process.
- Is deferred revenue a liability?
Yes, deferred revenue is recorded as a liability on the balance sheet until the company fulfills its obligations. It represents an obligation to deliver goods or services in the future.
- How is deferred revenue different from accrued revenue?
Deferred revenue involves receiving payment before providing goods or services, while accrued revenue refers to recognizing revenue before receiving payment. Both concepts aim to match revenue with the appropriate period but differ in terms of the timing of payment.
- Can deferred revenue be converted into cash?
Yes, deferred revenue is converted into cash over time as the company fulfills its obligations and recognizes revenue. The initial payment received is not recognized as revenue until the corresponding performance criteria are met.
- Can deferred revenue affect a company’s financial ratios?
Yes, deferred revenue can impact financial ratios, especially those related to liquidity and solvency. High levels of deferred revenue may indicate that a company has significant future obligations and may not have sufficient cash inflows in the short term.