What is deferred revenue?
Deferred revenue, also sometimes called “unearned” revenue or deferred income, is any revenue that you collect from your customers before earning it—a prepayment on a big web design project, collecting a year of rent payments upfront, or a retainer for legal services, for example.
You record deferred revenue as a short term or current liability on the balance sheet. Current liabilities are expected to be repaid within one year unlike long term liabilities which are expected to last longer. Deferred revenue is a short term liability account because it’s kind of like a debt however, instead of it being money you owe, it’s goods and services owed to customers.
Deferrals like deferred revenue are commonly used in accounting to accurately record income and expenses in the period they actually occurred. An example of deferred revenue is a retainer fee charged by law firms. When a legal practice charges a new client a $10,000 retainer fee, it isn’t immediately recorded as revenue in its books. It records it as deferred revenue first, and only records $10,000 in revenue after the entire retainer fee has been earned.
Deferred revenue and accrued expenses
A similar term you might see under liabilities on a company’s balance sheet is accrued expenses. Whereas deferred revenue is money that a business has received but hasn’t provided the good or services for, accrued expenses are incurred when a business has received the good or service, but hasn’t paid the money.
For example, if a business pays out a performance bonus annually and one of their employees has been smashing goals every month, the bonuses are adding up. Or, in accounting speak, they’re accruing. With each month, a business can record the performance bonuses as a liability on their balance sheet to accurately record what they’ll need to pay out at the end of the period.
Further reading: A Primer on Accrued Expenses (What You Need to Know)
How does deferred revenue work under cash and accrual accounting?
If your business uses the cash basis of accounting, you don’t have to worry about deferred revenue. According to cash basis accounting, you “earn” sales revenue the moment you get a cash payment, end of story.
Under accrual basis accounting, you record revenue only after it’s been earned—or “recognized,” as accountants say. When accountants talk about “revenue recognition,” they’re talking about when and how deferred revenue gets turned into earned revenue. The standard of when revenue is recognized is called the revenue recognition principle.
Knowing when to recognize revenue is one reason why we have Generally Accepted Accounting Principles (GAAP), which include detailed rules around revenue recognition that are tailored to each business type and industry.
These rules can get complicated—and to top it off, the Financial Accounting Standards Board (FASB) recently overhauled them. For a detailed rundown of how to recognize revenue under the new GAAP rules, check out our guide to revenue recognition.
Why is deferred revenue classified as a liability?
Because it’s technically money you owe your customers
Even though it has the word “revenue” in it, deferred revenue is a liability because it represents goods or services you owe to your customers. Remember: just because that money is in your bank account doesn’t mean your client won’t ask you for a refund in the future.
Some industries also have strict rules around what you’re able to do with deferred revenue. For example, most lawyers are required to deposit unearned fees into an arms-length IOLTA trust account. The penalties for removing unearned cash from an IOLTA account can be harsh—sometimes even leading to disbarment.
It prevents you from overvaluing your business
Deferred revenue is classified as a liability, in part, to make sure your financial records don’t overstate the value of your business. A SaaS (software as a service) business that collects an annual subscription fee up front hasn’t done the hard work of retaining that business all year round. This inflates the valuation of the business. Classifying that upfront subscription revenue as “deferred” helps keep businesses honest about how much they’re really worth.
Investors also want to make sure your assets and liabilities are spelled out clearly in your financial records—following GAAP rules ensures that you’re not prematurely recording liabilities (like deferred revenue) as assets (like cash).
An example of deferred revenue accounting
Let’s say you run a local gym, and at the beginning of the year you sell an annual membership to your friend Sam for $2,400.
Because you haven’t earned any of that revenue yet, you’d record Sam’s $2,400 payment to the gym as deferred revenue using the following journal entry:
|Deferred Revenue (Liability)||$2,400|
Because the membership entitles Sam to 12 months of gym use, you decide to recognize $200 of the deferred revenue every month—$2,400 divided by 12.
Let’s say you sold Sam the membership on January 1st. That means you would make the following journal entry on January 31st, to decrease the deferred revenue liability by $200 and increase membership revenue by $200.
|Deferred Revenue (Liability)||$200|
|Membership Revenue (Revenue)||$200|
You would continue to recognize $200 of the revenue at the end of every month until the deferred revenue account reaches zero, at which point the full $2,400 would be recorded as earned revenue on your annual income statement.
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What kinds of businesses deal with deferred revenue?
Any business where a customer pays in advance will carry deferred revenue on its books. Popular examples include:
- Professionals who collect retainers (lawyers, consultants, developers)
- Airlines and hotels
- Concert and sports ticketing services
- Cleaning and housekeeping services
- Businesses that collect rent
- Prepaid insurance
- Businesses that charge subscription fees (magazines, SaaS companies, meal delivery services)
- Businesses that charge membership fees (professional associations, private clubs, gyms)
- Contractors that charge an up-front deposit
Even if you don’t have any deferred revenue on your books, consider whether any of the income your business is earning now is paying for something you owe customers in the future.
For example: let’s say you recently charged a client a total of $20,000 for a website redesign. And let’s say your contract with the client includes website maintenance and support for a year after the delivery date.
Since you haven’t delivered on all the website support throughout the year yet, you should classify the support fee separately in your contract, and only recognize that revenue as you earn it.
A few practical things to know about deferred revenue
You shouldn’t spend it the same way you spend regular cash
While cash from deferred revenues might sit in your bank account just like cash from earned revenues, the two are not the same. If you don’t deliver the agreed-upon good or service, or your customer is unhappy with the end product, your deferred revenues could be at risk. Generally speaking, you should be more careful spending cash from deferred revenues than regular cash.
It’s a good kind of debt
Although it’s a liability, having a deferred revenue balance on your books isn’t necessarily a bad thing. In fact, as long as you’re able to deliver the goods and services you promised them, it’s generally better to get financing from your customers in the form of deferred revenue than it is to get a line of credit from a bank.
It’s crucial to understanding your company’s cash flows
Collecting deferred revenue means that your company’s revenue and its cash flow will be recorded in different periods: the cash flow is recorded immediately, while revenues are recorded once the revenue is earned. If you collect lots of deferred revenue, low cash flow this month doesn’t necessarily mean low revenues, and vice versa.
If your business collects lots of unearned revenue, it can be hard to read your financial statements and take stock of how your business is doing without understanding the difference between earned and unearned revenue. It’s also good practice to generate cash flow statements to best understand how deferred revenue affects cash going in and out of your business.
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