What is deferred revenue?

Deferred revenue, also known as unearned revenue or prepaid income, is an accounting concept that represents payments received by a company for goods or services that have not yet been delivered or performed. 

It is recorded as a liability on the balance sheet until the goods or services are delivered or performed, at which point it is recognized as revenue.

The existence of deferred revenue on a company's balance sheet indicates that it has received cash from customers but has not yet provided the corresponding goods or services. This liability represents a future obligation that the company must fulfill to avoid breaching its contractual agreement with the customer.

How does deferred revenue work?

Generally accepted accounting principles (GAAP) play a crucial role in the accounting treatment of deferred revenue. GAAP establishes the rules and guidelines that companies must follow when preparing their financial statements, including the recognition, measurement, and disclosure of deferred revenue.

Here's how GAAP and deferred revenue are related:

Recognition: GAAP requires companies to recognize deferred revenue as a liability on the balance sheet when they receive payment for goods or services that have not yet been delivered or performed. This ensures that the company's financial statements accurately reflect its outstanding obligations to customers.

Measurement: GAAP provides guidance on how to measure the amount of deferred revenue that should be recorded. Typically, the amount is equal to the cash or other consideration received from the customer. However, in some cases, GAAP may require companies to estimate the fair value of the goods or services to be delivered or performed.

Disclosure: GAAP requires businesses to disclose information about their deferred revenue in their financial statements. This disclosure includes the amount of deferred revenue, the nature of the transactions giving rise to the deferred revenue, and the timing of when the revenue is expected to be recognized.

What is the deferred revenue process?

GAAP provides a framework for the accounting treatment of deferred revenue, ensuring that companies follow consistent and transparent practices. This helps to improve the comparability and reliability of financial statements and allows stakeholders to make informed decisions.

Here's an expanded explanation of the process:

1. Receipt of payment:
   
   • When a company receives payment for future goods or services, it initially records it as an asset in the form of cash or accounts receivable.
   • However, this payment represents a liability because the company has an obligation to deliver the goods or services in the future.
2. Recording as a Liability:
   
   • The amount received is subsequently reclassified as a current liability on the balance sheet under the heading "Deferred Revenue" or "Unearned Revenue."
   • This liability reflects the company's outstanding obligation to fulfill its contractual commitments.
3. Recognition of revenue:
   
   • As the company delivers the goods or performs the services over time, a portion of the deferred revenue is recognized as revenue.
   • This recognition is typically done in accordance with the matching principle, which states that revenue should be recognized when it is earned, not when cash is received.
   • The amount of revenue recognized in each period depends on the terms of the contract and the stage of completion of the goods or services.
4. Matching principle:
   
   • The matching principle is crucial in ensuring that a company's revenues and expenses are properly matched in the same period.
   • By deferring the recognition of revenue until the goods or services are delivered or performed, companies avoid overstating their profits in the period of receipt.
5. Balance sheet presentation:
   
   • Deferred revenue is typically reported as a current liability on the balance sheet, as it represents a short-term obligation that the company must fulfill.
   • The presence of deferred revenue on the balance sheet provides valuable insights into the company's future obligations and cash flow expectations.
6. Impact on financial statements:
   
   • Deferred revenue can have a significant impact on a company's financial statements:
     
     • It affects the company's current ratio and other liquidity metrics, as it represents a source of cash that cannot be immediately used.
     • It influences the company's profitability, as the recognition of revenue over time can smooth out income fluctuations.
     • It provides insights into the company's business model and customer contracts, as it reflects the timing of cash inflows and obligations.

Overall, deferred revenue is an important accounting concept that ensures accurate financial reporting and provides valuable information for your finance team to assess a company's financial health and contractual commitments.

Is deferred revenue an asset or a liability?

Deferred revenue is a liability.

When a company receives payment for goods or services that have not yet been delivered or performed, it initially records it as an asset in the form of cash or accounts receivable. However, this payment represents a liability because the company has an obligation to deliver the goods or services in the future.

Examples of deferred revenue

To ensure you fully understand the details of deferred revenue, here are some real-world examples of how it works in real life scenarios:

1. A company receives payment for an annual subscription to its software service.
   
   • The customer pays for access to the software for a year in advance.
   • The company defers the revenue until the service is provided over the course of the year.
   • This is because the company has not yet earned the revenue until the customer has access to and uses the software.
   • As the service is provided each month, a portion of the deferred revenue is recognized as revenue.
2. A company receives payment for a gift card that can be used to purchase products or services in the future.
   
   • The customer pays for a gift card that can be used to purchase products or services in the future.
   • The company defers the revenue until the gift card is redeemed.
   • This is because the company has not yet earned the revenue until the customer has redeemed the gift card for products or services.
   • Once the gift card is redeemed, the company recognizes the revenue.

How do you report deferred revenue?

The reporting of deferred revenue can be largely broken down into three sections:

Recognition and measurement

• Recognition: Deferred revenue is initially recorded when cash or other consideration is received from customers. The recognized amount is equal to the cash or consideration received.
• Timing: Revenue recognition for deferred revenue occurs over time as the company delivers goods or performs services. This is known as the matching principle, where revenue is recognized when it is earned.

Financial statement disclosure

• Requirement: Disclosure of deferred revenue is mandatory in financial statements. Companies must provide detailed information about the nature, timing, and amount of deferred revenue. 

Impact

• Liquidity: Deferred revenue can impact a company's liquidity. Since it represents a liability, it reduces cash flow and cash equivalents available to the company. This can affect the company's ability to meet its short-term obligations.
• Profitability: Deferred revenue can also affect a company's profitability. When revenue is recognized over time, it can smooth out earnings and reduce volatility. This can make a company's financial performance appear more consistent.

Deferred revenue: A critical part of your financial statements

Deferred revenue has a significant impact on a company's financial statements, affecting liquidity metrics, profitability, and insights into the business model and customer contracts. It is important for accounts receivable departments to understand and analyze deferred revenue when evaluating a company's financial health and contractual commitments.

For more information on improving liquidity, check out the Chaser blog. To talk to an expert about how Chaser can reduce your DSO and improve your cash flow, book a demo with a member of the team. 

To get started on chasing down the money your company is owed, without adding to the workload of your accounts receivable team, start your no-obligation 14-day free trial today!