What Is Deferred Revenue?
Deferred revenue is an integral aspect of many popular business models, but it needs to be managed correctly to avoid problems down the road. Deferred revenue is recorded differently depending on whether you use an accrual or cash-basis accounting system.
Having an appropriate accounting system in place and keeping up-to-date records will help you ensure the correct handling of deferred revenue. It will also improve the financial stability of your business as you will be prepared to process refund requests if and when they come in.
What Is Deferred Revenue, Exactly?
Deferred revenue, also known as deferred income or unearned revenue, is money that a business has received but has not yet earned. This occurs when a client makes an advance payment for a good or service that the business has not yet delivered or provided.
Which Business Models Involve Deferred Income?
Unearned revenue is used in many businesses in today's market. The following are a few examples of industries and business models that involve deferred revenue.
Subscription Services
Companies that offer subscriptions, such as movie streaming companies, use a deferred revenue model in which the customer pays in advance for access to movies. Another example of deferred revenue is a software company that charges an annual subscription before the full year of software access has been delivered.
Physical subscription-based products work similarly. A customer might pay upfront for a year’s worth of newspapers, magazines, or beauty product boxes, which they will then receive regularly during the year with no further transactions required.
Rent Payments
A tenant may offer to pay a landlord several months of rent payments in advance, or a landlord might request it if a new tenant has no rental history and advance rent payments are legal in their state. In both cases, the funds are received before the entire rental benefit has been delivered.
Advance Ticket Sales
The entertainment industry uses deferred revenue when selling tickets for concerts, games, or races. Airlines also take advance cash payments from customers for upcoming flights.
Prepaid Insurance Premiums
Insurance companies collect premiums from policyholders in exchange for an agreed-upon length of future coverage.
Tuition Fees
Educational institutions such as colleges and universities receive deferred revenue when accepting tuition payments before the beginning of the school year.
Why Deferred Revenue Is Considered a Liability
The reason deferred revenue is considered a liability is that the income has not yet been earned. If the business is not able to follow through with its offer of goods or services or the customer decides to cancel the order, the revenue will need to be available to reimburse the customer. As just one example, 1.7% of flights in the United States were canceled in the first seven months of 2023. While this percentage is very small, it still represents a significant amount of money.
Important note: Deferred revenue is only recorded as a liability in accrual accounting. In a cash-basis accounting system, you record the cash when it comes in and that’s the end of the story. There is no need to record liabilities and later recognize the relevant portion as revenue. However, it’s still necessary to have a system in place to ensure the funds are available in case the customer requests a refund for all or part of the amount.
How Deferred Revenues Are Recorded
Deferred revenue that is expected to be earned in the near future is recorded as a current liability on the balance sheet. The amount is recorded as long-term liability if the goods or services are not expected to be provided to the customer within the next 12 months, or during the company’s current operating cycle if the operating cycle is longer than 12 months.
Recognition of Deferred Revenue
As the goods or services the company owes are rendered, the unearned income is recognized as earned revenue. As time goes on, the business earns the income by providing the services that were paid for. This then lessens the balance in the deferred revenue account and increases the balance in the revenue account. Take note that, depending upon the agreement, the seller may not be able to recognize revenue until the customer receives all of the agreed-upon services.
Fictitious Deferred Revenue Examples
Here are two examples of deferred revenue and how it would be recorded.
Construction
A construction contractor in Spartanburg, South Carolina may be hired to build a house for $100,000. He may require a $35,000 down payment at the time the contract is signed. The remaining $65,000 would be received at the end of the project when the building is finished. In this example, the $35,000 down payment would be recorded as a liability in the balance sheet and would later be recognized as earned revenue at the completion of the project.
Gym Memberships
A fitness center in Jacksonville, Florida offers monthly gym memberships for $20. A new client signs up for a yearly membership and makes a cash payment of $240, paying for the entire contract upfront.
In accounting, the gym would record this paid amount as deferred revenue on its balance sheet because it has not yet provided the entire year of membership. In each month of the year-long membership, the gym would recognize $20 of the deferred revenue as earned revenue and subtract the same $20 from its deferred revenue liability. At the end of the year, the entire amount will have been earned and can be included in the gym’s annual income statement.
Reasons for Managing a Deferred Revenue Account
Managing the deferred income received from customers appropriately helps ensure the following:
Accurate financial reporting
Improved budgeting
Customer retention
Operational efficiency
Reduced borrowing needs
Growth opportunities
The following are three of the most important reasons for ensuring you handle deferred revenue correctly:
Customer Refunds
Sometimes, you may need to refund customers’ payments. If you do not record deferred revenue correctly, you may end up with financial strain and limited money in your cash account.
Stakeholder Distrust
Poor deferred revenue accounting can tread on stakeholders' trust. Investors, employees, and other business partners may begin to question the integrity of the business.
Audit Findings
When deferred revenue is considered through accounting audits, the auditor may find discrepancies or other issues with the asset account, liability account, or other general problems on the income statement. These kinds of audit findings are red flags for both investors and creditors.
Handle Deferred Revenue Correctly from the Start
To make sure your business is handling deferred revenue correctly, check the Financial Accounting Standards Board website for the most up-to-date rules and regulations on revenue recognition. Our bookkeeping for beginners guide can also help new businesses set up a system for recording transactions.
Maintaining accurate records and classifying each transaction correctly is essential for ensuring you can issue refunds to customers without getting into debt. If you are concerned that you may not be handling your deferred revenue effectively, consult a small business accounting agency for advice.
