What is Deferred Revenue?
Deferred Revenue (or “unearned” revenue) is created when a company receives cash payment in advance for goods or services not yet delivered to the customer.
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Deferred Revenue in Accrual Accounting
If revenue is “deferred,” the customer has paid upfront for a product or service that has yet to be delivered by the company.
Under accrual accounting, the timing of revenue recognition and when revenue is considered “earned” is contingent on when the product/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/services.
Examples of Deferred Revenue
In each of the following examples listed above, the payment was received in advance and the benefit to the customers is expected to be delivered on a later date.
Gradually, as the product or service is delivered to the customers over time, the deferred revenue is recognized proportionally on the income statement.
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 of 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 Example Calculation
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.