If you’re a business owner, you know that revenue is the amount of money you make when you sell a product or service.
But what if your customer pays you up front? You have the cash, but you haven’t done anything to earn it. This is where deferred revenue comes in.
Now we will learn the basics of deferred revenue and how it works. Accounting for your business.
What is deferred revenue?
In business, a customer may pay for a service that they will receive six months from now, or even 24 months from now, meaning they have the cash but haven’t performed the service or delivered the product yet.
Deferred revenue is money a company receives from a customer for future services or products. Think of the purchase of a gift card.
You buy a $100 gift card to your favorite bookstore. The bookstore receives the $100, but hasn’t sold any books yet. The bookstore records the $100 as deferred revenue until the gift card is used.
Accounting RulesYou should not allow the store to take the full $100 as revenue because they have not given you any right to that money, even if it is not explicitly stated: Business Transactions It is a contract that sets out the obligations and rights of each party.
In the example above, the store has an obligation to sell you the book and has the right to cash the gift card after delivering the book. Cash that you receive before providing a service or delivering a product is called deferred revenue. Postponed the Revenue or Passive Income Revenue.
How deferred revenue works in accounting
A set of accounting principles defines how transactions are recorded on a company’s books. There are 10 accounting principles, and the one that is most relevant to deferred revenue is the revenue recognition principle.
The principle of revenue recognition states that revenue is recorded when it is earned, regardless of when the cash payment is received. For example, a SaaS company sells a two-year software license and receives $100,000 in full. Because the company hasn’t yet earned the $100,000, it can’t immediately recognize the amount upfront as revenue.
Instead, the company recognizes revenue incrementally as it provides the software services over the two-year period. The company records revenue of $4,166 ($100,000 ÷ 24 months) each month during the two-year license term.
Companies must record advances as deferred revenue until they earn the cash advance by providing services or delivering products. See Amazon’s December 31, 2023 balance sheet.
Ignore all the words and numbers and only look at the items in the red box.
As of December 31, 2023, Amazon had accrued revenue of $15.2 billion. If we read further into Amazon’s annual financial report, we can see that their accrued revenue looks like this:
Deferred and unearned revenue
There’s a subtle difference between deferred revenue and accrued revenue. Keep in mind that deferred revenue occurs when a business receives cash but hasn’t provided services or delivered products.
Accrued revenue is the opposite of deferred revenue, which is when a business has not yet received payment for goods or services it has already provided.Another of the 10 basic accounting principles is the accrual basis.
Under the accrual principle, transactions are recorded in the accounting books when the expense is incurred or the revenue is earned, regardless of when cash changes hands. For example, payroll expenses are recorded when they are due to be paid, not when you deposit the paycheck directly into an employee’s bank account.
Similarly, you record revenue when you deliver products to customers as agreed upon, not when you receive cash. accounts receivableIf a customer owes you money, don’t omit these amounts from your financial books.
The same thing ExpensesDon’t forget them Financial StatementsFor example, if a business doesn’t pay payroll for a month, when the business closes its books at the end of the month, it needs to recognize the unpaid payroll as an expense and a liability.
How deferred revenue impacts financial statements
Revenue is an income item, Profit and loss statementWhat about deferred revenue? For accounting purposes, deferred revenue is a liability, not revenue, so it impacts the financial statements differently.
The reasons are as follows:
Any cash you receive for services you don’t provide isn’t technically yours. You hold it in trust. It only becomes yours when you earn it. And things can change, especially if it’s before you provide the services you agreed to.
For example, let’s say a customer pays $10,000 for a two-year SaaS software license – what happens if the next morning they change their mind or experience a significant business interruption and ask for a refund?
Sure, you could have a no refund policy and keep the cash, but you shouldn’t owe it back because you haven’t done anything to deserve it.
Accounting somehow captures this natural sense of justice by stating that deferred revenue should be recognized as a liability, not revenue. When you deliver the service or product that was paid for in advance, the deferred revenue liability disappears. You then record that amount as revenue.
How to manage and track deferred revenue
The best way to manage and track deferred revenue is with a revenue recognition schedule, which involves capturing an initial, gross upfront payment and then gradually reducing that amount as the company performs the agreed-upon services.
Let’s say you have a customer who signed a 12-month contract for $12,000 on January 1. The contract has recurring fees of $3,000 per quarter.
The revenue recognition schedule is as follows:
| period | Revenue recognized to date | Deferred Revenue Balance |
|---|---|---|
| January 1 | $0 | $12,000 |
| March 31 | $3,000 | $9,000 |
| June 30 | $6,000 | $6,000 |
| September 30 | $9,000 | $3,000 |
| December 31 | $12,000 | $0 |
Understanding the deferred revenue portion represents a promise of future service delivery and potential reimbursements, helping to prevent overspending. Additionally, tracking deferred revenue allows businesses to make more accurate and realistic plans. Cash flow Forecasting to plan staffing needs, marketing activities, and more.
Tracking deferred revenue can improve the accuracy of your financial statements. In the example above, let’s say your company signed a 12-month contract in December and recorded the full $12,000 as revenue in December.
This means that December revenues are inflated and the company ends up not recording revenue for the following year.Today, technology makes it much easier to manage and track deferred revenue.
largely Accounting software They have revenue recognition capabilities that update deferred revenue in real time. These accounting systems provide charts, graphs, and tables that break down revenue by month, showing how much revenue the company has earned and how much is still deferred.
Deferred Revenue Risk
While it may seem simple, deferred revenue comes with its own set of risks that your business must address. How you manage these risks can make all the difference between a better financial position for your company and happy customers somewhere.
Below are some general risks associated with deferred revenue:
Cash flow management challenges
One of the most common risks associated with deferred revenue is Cash Flow ManagementConsider a company that receives a large amount of cash from a client at the beginning of the year for a year-long software implementation project.
However, the company is using all of that cash to fund growth and expansion through new marketing initiatives, leaving no cash left to pay the salaries of consultants who do implementations throughout the year.
Without careful planning, you could run out of funds midway through the project, jeopardizing the success of the project and your company’s finances. Ability to pay.
Inaccurate financial statements
Recording and tracking deferred revenue can be complex and requires a strong accounting process. Errors in tracking deferred revenue can lead to inaccurate financial statements.
As a result, you may mislead investors, creditors and even regulators. In some cases, violating accounting standards and regulations may result in fines, penalties and legal action.
Customer Service Risk
Without recording deferred revenue, businesses can easily forget about promises, which can lead to delayed or missed fulfillment of customer orders, creating stress for businesses.
Customers expect companies to keep their promises, and when companies mismanage deferred revenue and fail to deliver on those promises, customer trust is eroded.
Deferred Revenue FAQs
Is deferred revenue a good thing?
Although deferred revenue is a liability, it’s not necessarily a bad thing. A company with deferred revenue can convert it into revenue once it has performed agreed-upon services or delivered products.
What is an example of deferred revenue?
Examples of deferred revenue include prepaid annual gym memberships, gift card purchases, or tickets to future events such as concerts or sporting events.
How is deferred revenue treated?
Deferred revenue is treated as a liability and is a company’s Balance sheet.
How do you record deferred revenue?
Deferred revenue increases the cash account and also increases the deferred revenue account, which is a liability.
