background
Welcome to Wall Street Prep! Use code at checkout for 15% off.
Wharton & Wall Street Prep Certificates
Now Enrolling for September 2024 for September 2024
:
Private EquityReal Estate Investing
Buy-Side InvestingFP&A
Wharton & Wall Street Prep Certificates:
Enrollment for September 2024 is Open
Wall Street Prep

Deferred Revenue

Step-by-Step Guide to Understanding Deferred Revenue in Accounting

Last Updated May 22, 2024

Learn Online Now

Deferred Revenue

In This Article
  • Deferred revenue is money received by a company in advance for products or services that have not been delivered.
  • Common examples of deferred revenue include rent payments received in advance, annual subscription payments received at the start of the year, and an unused gift card.
  • Deferred revenue is recorded as a liability on the balance sheet, since the company has an unmet obligation to the customer until the product or service is delivered.
  • Deferred revenue is not recognized as revenue on the income statement until earned under accrual accounting standards.

How is Deferred Revenue Created?

Deferred revenue—or “unearned” revenue—arises if a customer pays upfront for a product or service that has not yet been delivered by the company.

Under accrual accounting, the timing of revenue recognition and when revenue is considered “earned” depends on when the product or service is delivered to the customer.

Therefore, if a company collects payments for products or services not actually delivered, the payment received cannot yet be counted as revenue.

During the time lag between the date of initial payment and delivery of the product/service to the customer, the payment is instead recorded on the balance sheet as “deferred revenue,” which represents the cash collected prior to the customer receiving the products or services.

What are Examples of Deferred Revenue?

For a transaction to be recognized as deferred revenue, the payment must be received in advance, so the benefit to the customer is expected to be delivered later.

Gradually, as the product or service is delivered to the customers over time, the deferred revenue is recognized proportionally on the income statement.

Common Examples

  • Unused Gift Cards
  • Subscription Plans (e.g. Annual Newspaper Subscription Plan)
  • Service Agreements Associated with Product Purchase
  • Implied Rights to Future Software Upgrades
  • Upfront Insurance Premium Payments

Is Deferred Revenue a Liability?

Following the standards established by U.S. GAAP, deferred revenue is treated as a liability on the balance sheet, since the revenue recognition requirements are incomplete.

Typically, deferred revenue is listed as a current liability on the balance sheet due to prepayment terms ordinarily lasting fewer than twelve months.

However, if the business model requires customers to make payments in advance for several years, the portion to be delivered beyond the initial twelve months is classified as a “non-current” liability.

A future transaction has numerous unpredictable variables, so as a conservative measure, revenue is recognized only once actually earned (i.e. the product/service is delivered).

The payment received from the customer receives treatment as a liability because of:

  • The company’s remaining obligations are to provide the products/services to customers.
  • The chance that the product/service is not delivered as originally planned (i.e. an unexpected event).
  • The potential inclusion of clauses in the contract that allow the cancellation of the order.

In all the scenarios above, the company must repay the customer for the prepayment.

Another consideration is that once the revenue is recognized, the payment will now flow down the income statement and be taxed in the appropriate period in which the product/service was actually delivered.

Deferred Revenue vs. Accounts Receivable: What is the Difference?

The difference between deferred revenue and accounts receivable is as follows.

  • Deferred Revenue → Unlike accounts receivable (A/R), deferred revenue is classified as a liability, since the company received cash payments upfront and has unfulfilled obligations to its customers.
  • Accounts Receivable → In contrast, accounts receivable (A/R) is essentially the opposite of deferred revenue, as the company has already delivered the products/services to the customer who paid on credit. For accounts receivable, the only remaining step is the collection of cash payments by the company once the customer fulfills their end of the transaction — hence, the classification of A/R as a current asset.

Deferred Revenue Calculation Example

Let’s say a company sells a laptop to a customer at a price tag of $1,000.

Of the $1,000 sale price, we’ll assume $850 of the sale is allocated to the laptop sale, while the remaining $50 is attributable to the customer’s contractual right to future software upgrades.

In total, the company collects the entire $1,000 in cash, but only $850 is recognized as revenue on the income statement.

  • Total Cash Payment = $1,000
  • Revenue Recognized = $850
  • Deferred Revenue = $150

The remaining $150 sits on the balance sheet as deferred revenue until the software upgrades are fully delivered to the customer by the company.

What is the Journal Entry for Deferred Revenue?

Suppose a manufacturing company receives $10,000 payment for services that have not yet been delivered.

The initial journal entry will be a debit to the cash account and credit to the unearned revenue account.

Journal Entry Debit Credit
Cash $10,000
      Unearned Revenue $10,000

After the services are delivered, the revenue can be recognized with the following journal entry, where the liability decreases while the revenue increases.

Journal Entry Debit Credit
Unearned Revenue $10,000
      Revenue $10,000
Step-by-Step Online Course

Everything You Need To Master Financial Modeling

Enroll in The Premium Package: Learn Financial Statement Modeling, DCF, M&A, LBO and Comps. The same training program used at top investment banks.

Enroll Today
Comments
6 Comments
most voted
newest oldest
Inline Feedbacks
View all comments
Riti Patel
March 2, 2023 4:04 pm

How is deferred revenue modeled? Or better any ideas on how to model it effectively?

Last edited 1 year ago by Riti Patel
Brad Barlow
March 5, 2023 9:02 pm
Reply to  Riti Patel

Hi, Riti, For businesses that have a lot of deferred revenue, the best approach is to understand how their bookings/billings work (e.g., for a SaaS company, something like the contract value per customer times the number of new customers plus repeat customers each period) and project those first, and then… Read more »

Bib Smith
May 2, 2023 12:31 pm
Reply to  Riti Patel

So when def rev goes up, cash goes up, but what ab when def rev goes down? Does cash go down?
Or when deferred rev goes down, inventory goes down and SE goes up?

Brad Barlow
May 4, 2023 12:29 pm
Reply to  Bib Smith

Hi, Bib,

That is correct: when D/R goes down, that means that Revenue goes up, and therefore Retained Earnings (part of SE) goes up, and yes, if it is a good sold, then COGS must go up and inventory must go down as well.

BB

Bob
November 7, 2023 9:13 pm

How about recognizing deferred revenue before the cash is received but contract with the customer is signed?

Brad Barlow
November 8, 2023 12:17 pm
Reply to  Bob

Hi, Bob,

A company may keep track of bookings and report it as a leading indicator, but deferred revenue, since it tracks cash received before revenue is recognized, needs to be recorded when cash is received.

BB

Learn Financial Modeling Online

Everything you need to master financial and valuation modeling: 3-Statement Modeling, DCF, Comps, M&A and LBO.

Learn More

The Wall Street Prep Quicklesson Series

7 Free Financial Modeling Lessons

Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.