Deferred Revenue

Deferred revenue refers to the money received in advance for goods or services that have not yet been delivered.

Author: Jo Vial Ho
Jo Vial Ho
Jo Vial Ho
Jo Vial currently works at DBS Bank's Group Research department. Prior to that, he has been an Air Traffic Controller and worked in a law firm. He is currently working towards a business and computer science double degree in Singapore.
Reviewed By: Sid Arora
Sid Arora
Sid Arora
Investment Banking | Hedge Fund | Private Equity

Currently an investment analyst focused on the TMT sector at 1818 Partners (a New York Based Hedge Fund), Sid previously worked in private equity at BV Investment Partners and BBH Capital Partners and prior to that in investment banking at UBS.

Sid holds a BS from The Tepper School of Business at Carnegie Mellon.

Last Updated:December 8, 2023

What Is Deferred Revenue?

Deferred revenue, also known as unearned revenue, refers to the funds received in advance for products or services that have not yet been provided. The term "deferred" signifies that the delivery of these items is postponed. The accounting process involves shifting liabilities to revenue and assets to expenses.

In this context, it pertains to the conversion of liabilities into revenue on the balance sheet. This is because money is transferred from customers' accounts into the business before the delivery of goods or services.

Examples of deferred revenue are commonly seen in various industries, such as training services, delivery services, or newspaper subscriptions. In these cases, customers prepay for services or goods, and the company is obligated to deliver them.

The opposite of this is accrued expenses, where services or goods are provided before payment is received. Businesses typically avoid this with individual customers due to the higher risk of non-payment.

Instead, they prefer unearned revenue payment arrangements with institutional clients, as these clients have more reputation at stake and may lose it if they refuse to make payments.

Furthermore, it's easier to pursue legal action against a single client than dealing with numerous individual clients who are not connected to each other.

Key Takeaways

  • Deferred revenue refers to money received in advance for goods or services yet to be delivered.
  • Accrued expenses are payments yet to be made for goods or services already received.
  • Accounting entries for accrued expenses involve debiting expenses and crediting accrued expenses.
  • Accrued revenue occurs when a good or service is provided on credit without receiving payment.

Deferred Revenue Accounting Book Entries

Let's assume that a newspaper company in New York has $1,000 in deferred revenue for its newspaper delivery service.

The following book entries illustrate the transactions:

Account name Debit Credit
Cash $1000 -
Unearned revenue - $1000

In this account, cash is debited such that cash is received. The company will make an adjusted entry to transfer the amount of services performed as a liability to a revenue account.

When the company pays back half of its service rendered, its account will be moved again. This time, unearned revenue will see a debit, and service revenue (which accords the income attributed to the actual service generated by the company) will see a credit increase.

Half of its service rendered, in monetary terms, is $1,000 x 0.5, which is $500, hence:

Account name Debit Credit
Unearned revenue $500 -
Service revenue - $500

Examples Of Situations With Deferred Revenue

Here are the examples of situations with deferred revenue:

  1. Software Industry: Software companies often offer subscriptions or annual licenses to their products. When a customer pays for a year's subscription upfront, the revenue is recognized gradually over the subscription period rather than all at once.
    • For instance, if a customer pays $1,200 for a 12-month subscription, the company would recognize $100 of revenue each month.
  2. Publishing Industry: Magazine publishers often sell annual subscriptions to their publications. Similar to the software industry, the revenue from these subscriptions is recognized over the subscription period rather than immediately upon payment.
  3. Airlines: Airlines frequently sell prepaid travel packages or loyalty programs, where customers pay in advance for a certain number of flights or benefits. The revenue is recognized as the flights or benefits utilized by the customer.
  4. Construction Companies: Construction companies may receive advance payments or deposits from clients for future construction projects. The revenue is recognized as the construction progresses and reaches specific milestones.
  5. Gym Memberships: Fitness centers and gyms often offer annual or monthly memberships. The revenue from these memberships is recognized over the membership period, allowing access to the facilities and services during that time.
  6. Event Ticketing Companies: Companies that sell tickets for events, concerts, or shows often receive payments in advance of the actual event date. The revenue is recognized when the event occurs and the service is delivered.
  7. SaaS (Software as a Service) Companies: Similar to the software industry, SaaS companies offer subscription-based services, and the revenue is recognized over the subscription period as the service is provided.
  8. Telecommunication Providers: Telecommunication companies may offer prepaid phone plans where customers pay for usage in advance. The revenue is recognized as the customer uses the services.
  9. Online Streaming Services: Streaming platforms that offer annual or monthly subscriptions receive payments in advance, and the revenue is recognized over the subscription period as customers access the content.

Deferred Revenue Risks And Challenges

There exist risks and challenges associated with the calculation of deferred revenue. Some examples are listed below:

  1. Revenue Recognition Complexity: Deferred revenue adds complexity to the accounting process. Companies must accurately track and allocate revenue over the performance period, adhering to generally accepted accounting principles (GAAP) and International Financial Reporting Standards (IFRS). 
  2. Customer Obligations: When a company receives advance payments, it creates obligations to deliver goods or services in the future. If the company fails to meet these obligations, it may result in customer dissatisfaction, reputational damage, and potential lawsuits, leading to loss of revenue and additional costs.
  3. Customer Churn: In industries with subscription-based models, there is a risk of customer churn before the entire deferred revenue is recognized. If customers cancel their subscriptions prematurely, the company might not fully realize the anticipated revenue, impacting financial projections.
  4. Economic Instability: During economic downturns or crises, customers may cancel subscriptions or reduce their prepayments, leading to decreased deferred revenue. This can affect the company's financial stability and ability to meet its obligations.
  5. Cash Flow Challenges: While deferred revenue enhances cash flow initially, it may lead to cash flow challenges in the future. If a significant portion of revenue is deferred, the company might have insufficient cash flow to cover current expenses or invest in growth initiatives.
  6. Over-Reliance on Deferred Revenue: Some companies heavily rely on deferred revenue models, which may lead to dependency on future performance. If the company faces unforeseen obstacles or challenges in delivering products or services, it could impact future revenue recognition and overall financial health.

Prepaid Expenses/Deferred Expenses

Deferred expenses are defined as money the business pays but has yet to receive goods/services from said payee company.

This could come in the form of business-to-business transactions, such as rent or payments for primary goods that a business that produces secondary goods would have to produce in advance, potentially in the form of swap/forward contracts for hedging.

For example, suppose a newspaper company spends $1,000 for a future paper contract with a paper-producing company. In that case, the newspaper company sees the $1,000 as deferred expenses as they are paying the paper company upfront without receiving the product yet.

Whereas for the paper-producing company, $1000 is the unearned/deferred revenue because it has received cash but has yet to deliver the product.

Account name Debit Credit
Cash - $1000
Unearned revenue $1000 -

The cash account is credited with $1,000, indicating a decrease in cash. Simultaneously, the unearned revenue account is debited with $1,000, as it represents the liability of the paper-producing company to deliver the product.

Deferred Revenue Vs. Deferred Expenses

Both terms are accounting concepts that involve the recognition of income or expenses in a future period rather than in the current period. While they share some similarities, the two also have key differences.

Let us take a look at the similarities:

  • Timing of Recognition: Both terms involve the recognition of transactions at a later point in time. The cash is initially received or paid, but the revenue or expense is not recognized until a specific event or condition is met.
  • Liability: Both terms create a liability on the balance sheet. They represent an obligation for the company to provide goods and services or incur future expenses.

Notable differences are:

  1. Nature of Transaction
    • Deferred revenue relates to income received in advance for goods or services that are yet to be delivered. It represents an unearned revenue that needs to be recognized as revenue when the goods or services are provided. 
    • On the other hand, deferred expenses refer to expenses paid in advance for goods or services the company has not yet received. These expenses are recognized as assets and are gradually expensed over time as the goods or services are consumed.
  2. Perspectives
    • Deferred revenue is viewed from the company's perspective. It represents a liability as the company owes a service or product to the customer.
    • Deferred expenses, however, are viewed from the payee's perspective. The company paying in advance considers it a deferred expense, while the recipient sees it as deferred revenue.
  3. Accounts Involved
    • Deferred revenue is initially recorded as a liability account, such as "Unearned Revenue," and is transferred to a revenue account when revenue is earned.
    • Deferred expenses, such as "Prepaid Expenses," are initially recorded as an asset account and are gradually expensed over time.

Accrued Revenue

Accrued revenue refers to income earned by a business for goods or services provided to another entity where no cash transfer has occurred yet. The transaction is conducted on credit, and payment has not been received. Revenue is recognized even though the customer has not been billed or invoiced.

For instance, a cotton company could have a good relationship with a clothes producer. As the clothes producer has been paying its dues regularly and on time, the company may reward the clothes producer with its goods and services in advance due to a contract drafted.

Hence, the cotton company gives the clothes producer $5,000 worth of cotton.

Account name Debit Credit
Accrued revenue $5000 -
Sales revenue - $5000

When the customer decides to pay, the cotton company will record the following transaction:

Account name Debit Credit
Accrued revenue - $5000
Sales revenue $5000 -

Deferred Revenue Vs. Accrued Revenue

Both accounting concepts involve the recognition of revenue in a period different from when the actual cash is received.

Let us understand the similarities between the two:

  1. Timing of Recognition: Both terms involve revenue recognition in a period different from when the cash is received.
  2. Revenue Recognition: Both terms represent revenue that has been earned but not yet received. They reflect the performance of a service or the delivery of goods, even though the actual cash transaction has not occurred.

Some of the differences are:

  1.  Cash Transaction
    • Deferred revenue arises when cash is received in advance for goods or services that are yet to be provided. It represents an unearned liability recognized as revenue when the goods or services are delivered. 
    • On the other hand, accrued revenue occurs after goods/services are provided, but the cash payment has not yet been received. It represents an earned asset recognized as revenue once the payment is received.
  2. Billing and Invoices
    • Deferred revenue typically involves situations where no billing or invoices have been submitted to the customer. The payment is made upfront, and the revenue is recognized when the related goods or services are provided. 
    • In contrast, accrued revenue may involve situations where the customer has been invoiced for the goods or services, but payment is pending. The revenue is recognized based on accrual accounting principles, even if the payment is pending.
  3. Transaction Recording
    • Deferred revenue is initially recorded as a liability account, such as "Unearned Revenue," and is later transferred to a revenue account once the revenue is earned. 
    • Accrued revenue, on the other hand, is initially recorded as an asset account, such as "Accounts Receivable," and is later transferred to a revenue account when the payment is received.

Conclusion

This article highlights important accounting concepts that involve the recognition of income or expenses at a later point in time. 

Deferred revenue refers to money received in advance for goods or services yet to be delivered. In contrast, deferred expenses refer to expenses paid in advance for goods or services the company has not yet received. 

Both concepts create liabilities on the balance sheet and involve the transfer of funds from one account to another when goods or services are provided or received.

On the other hand, accrued revenue and accrued expenses are similar concepts that involve the recognition of revenue or expenses before the corresponding cash transactions occur. 

Accrued revenue occurs when goods or services have been provided, but payment has not yet been received, while accrued expenses refer to expenses that have been incurred but not yet paid. 

Both concepts represent assets on the balance sheet and are eventually transferred to revenue or expense accounts when cash transactions occur.

While deferred revenue and deferred expenses are viewed from the company's perspective, accrued revenue and expenses are viewed from the perspective of the party receiving or providing the goods or services.

The accounts used to record these transactions differ, with deferred and accrued revenue initially recorded as liability or asset accounts, respectively, and later transferred to revenue accounts.

Note

Deferred and accrued expenses are initially recorded as asset or liability accounts, respectively, and are gradually expensed over time.

Understanding the differences between deferred and accrued revenue and deferred and accrued expenses is essential for sound financial management and reporting.

By appropriately recording and managing these transactions, businesses can maintain accurate financial statements and make informed decisions about their operations.

Researched and authored by Jo Vial | LinkedIn

Reviewed and edited by Parul Gupta | LinkedIn

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