Deferred Revenue: Liability Classification (“Unearned”)
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 categorized as a “non-current” liability.
A future transaction comes with 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 remaining obligations by the company are to provide the products/services to customers.
- The chance that the product/service is not delivered as originally planned (i.e. unexpected event).
- The potential inclusion of clauses in the contract that allow for the cancellation of the order.
In all the scenarios stated 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
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.
In comparison, 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 that 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.
How is deferred revenue modeled? Or better any ideas on how to model it effectively?
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 »
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?
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.