What deferred revenue is and why it matters for your business finances
Understanding deferred revenue can help small businesses accurately record payments they've received before work has been completed. Presented by Chase for Business.
- Deferred revenue represents payments received for goods or services to be provided in the future.
- It is usually listed as a liability on a company’s balance sheet because it represents work that is not yet completed.
- Understanding deferred revenue can help provide a more complete picture of a business’s overall financial health.
Deferred revenue is a common term in business accounting. For many small business owners, understanding deferred revenue may help support more informed financial choices as well as improve the accuracy of financial reports.
In this article, we'll explain what deferred revenue is, why it's considered a liability, describe how to account for it and outline its role in helping to determine your business's financial health. You may want to consult with an accounting professional about your specific situation.
What is deferred revenue?
Deferred revenue—sometimes referred to as unearned revenue—is the money your business receives from customers in advance of providing goods or services. This typically happens when clients pay upfront for items, subscriptions or services that will be delivered later.
Example: If your customer pays in advance for a 12-month software subscription, you collect the cash immediately, but the revenue is not yet earned.
You may still be required to deliver service throughout the subscription period. Until then, this payment is recorded as deferred revenue on your balance sheet. When you earn the revenue by fulfilling your promise, it becomes part of your recognized income.
Why deferred revenue is considered a liability
Deferred revenue is listed as a liability on your balance sheet because it represents a commitment to provide goods or services to customers in the future. Taking advance payments creates an obligation that you'll need to meet later.
If your business is unable to fulfill the promise, you may have to refund the customer or offer compensation. Until the agreed goods or services are delivered, the funds received aren't recognized as earned revenue.
Deferred revenue is typically shown as a current liability if you expect to deliver the goods or services within the next 12 months. If the obligation extends beyond a year, it might be recorded as a long-term liability. This classification can help lenders and investors more accurately evaluate your company's liquidity and financial standing.
How deferred revenue is recorded
On the balance sheet, deferred revenue typically appears under "current liabilities" or "long-term liabilities" depending on when you deliver the product or service. Only when you deliver the goods or perform the service does that liability shrink and a corresponding amount flow onto the income statement as recognized revenue.
This timing matters: Recording the cash as revenue too early can overstate your performance and understate your obligations, which may mislead lenders, investors and even you about the health of the business.
The business accounting principles behind this treatment are revenue recognition and the matching principle:
- Revenue recognition tells you to record income only when it's "earned,” regardless of when cash changes hands.
- The matching principle reinforces this by keeping costs and the revenue they help generate in the same period.
How to recognize deferred revenue in your books
Reconciling deferred revenue is a matter of systematically tracking how much of a prepaid obligation you've satisfied each month or quarter, moving that portion from the liability account to revenue and documenting the rationale so an auditor or accountant can follow the trail.
Here is an example of what the process looks like:
- Record: When a customer pays $1,200 upfront for a 12-month service contract, you record the amount as deferred revenue (a liability) on your balance sheet.
- Recognize: As you deliver the service each month, recognize $100 as earned revenue and reduce deferred revenue by $100.
- Reconcile: Each month, confirm the deferred revenue balance matches what is still owed to the customer. After 12 months, deferred revenue reaches $0 and the full $1,200 has been recognized as revenue.
Accrued revenue vs. deferred revenue
It can be important to distinguish between accrued revenue and deferred revenue for correct accounting. Both relate to timing differences between cash flow and revenue recognition, but they are opposite in nature.
- Accrued revenue occurs when you have delivered goods or services but have not yet received payment. Revenue is recognized and accounts receivable is recorded until payment arrives.
- Deferred revenue is when you receive payment before delivering goods or services, so it appears as a liability until the revenue is earned.
Accrued revenue is recognized before cash is received, whereas deferred revenue involves collecting cash before recognizing revenue. Knowing the difference can help keep your financial statements accurate and may prevent errors in revenue reporting.
Why is deferred revenue important?
Deferred revenue may provide more accurate information about the overall financial health of your business in a few key areas:
- Cash flow management: Advance payments can help fund your operations, but keep in mind that these are not yet earned income. This makes deferred revenue a key part of your cash flow management.
- Accurate reporting: Tracking deferred revenue may help ensure your financial statements fairly represent your company's results.
- Risk oversight: Treating deferred revenue as a liability can help highlight your service commitments and fulfill potential refunds.
- Stakeholder confidence: Investors and lenders may use deferred revenue figures to judge your future cash flow and ability to meet obligations.
Keeping track of deferred revenue can help support sound financial planning and may build credibility with those who review your business's finances.
Frequently asked questions
What are some common examples of deferred revenue for small businesses?
Examples include prepaid service agreements, annual software licenses, advance ticket sales and retainer fees for consulting.
How does deferred revenue compare to accounts payable?
Deferred revenue is payment you have received for goods or services not yet delivered. Accounts payable is money you owe suppliers for goods or services received. Both are liabilities, but deferred revenue relates to customers, while accounts payable concerns vendors.
Who would look at your deferred revenue?
Your deferred revenue may be important to investors, lenders, auditors and business owners to help evaluate your financial obligations and income potential.
What's the difference between deferred revenue and deferred expenses?
Although deferred revenue and deferred expenses sound similar, they refer to different accounting concepts. Deferred revenue is money you receive in advance for goods or services not yet provided, and is recorded as a liability. Deferred expenses are payments you make ahead of time for goods or services. They are typically recorded as an asset until used.
