According to Generally Accepted Accounting Principles (GAAP) and industry standard ASC 606, a company shouldn’t recognize revenue until it’s been earned. In other words, it should only record revenue after its goods or services have been delivered to the customer.
This sounds pretty straightforward, but what happens when a customer makes a payment before the product or service has been fulfilled? How should an organization’s accounting team handle this income on its financial statements?
Here’s where deferred revenue comes in. Also known as unearned revenue, deferred revenue is income received for goods or services that have yet to be provided. It’s critical that accounting teams understand how to classify this type of revenue and when and how to record it to ensure accurate financial reporting.
Properly accounting for deferred revenue on a balance sheet reduces overstating revenue where revenue is recognized prematurely and helps investors and stakeholders confidently assess a company’s financial health.
Given that, this article aims to explore all the nuances of deferred revenue, explain how it differs from recognized revenue, and walk through the process of recording it in accordance with GAAP.
What Is Deferred Revenue?
A good place to start is by defining the term deferred revenue. Put simply, deferred revenue is income received for goods or services that haven’t yet been delivered or rendered. In this case, the payment is recorded upfront, which creates a liability until the obligation is fulfilled. Examples include pre-payments, deposits, and retainers.
This is the opposite of accrued revenue, which is income that’s been earned but not yet received. While both involve timing differences between cash receipt and revenue recognition, deferred revenue resides as a liability on the balance sheet until the service or product is provided, whereas accrued revenue reflects revenue earned but awaiting invoicing or payment.
Companies generally use a deferred revenue account to accurately depict their financial obligations and revenue recognition timelines.
With the roll-out of ASC 606, there was a slight adjustment to the terminology for deferred revenue, as well as accrued revenue. Now, if an agreement has deferred revenue, it is referred to as being in the “contract liability” position whereas accrued/unbilled revenue is now known as being in the “contract asset” position.
Examples of Deferred Revenue
Deferred revenue is used in many different sectors and various situations.
For example, the annual subscription payments that many subscription-based services receive generate deferred revenue until the services are rendered. So if a customer pays $12,000 upfront in subscription revenue for a one-year term, the subscription revenue recognition would be $1,000 per month.
|Deferred Revenue Balance
Industries like construction and software development also frequently rely on deferred revenue. They typically receive payments before the job is completed, necessitating the usage of deferred revenue on their balance sheets.
In addition, the receipt of advance payments is common in sectors like real estate and retail, creating deferred revenue until the products or services are delivered. This requires meticulous tracking on behalf of accounting teams to ensure accurate financial reporting that reflects all the complexities of deferred revenue management and the revenue recognition principle.
Why Is It Important?
There’s no getting around the fact that deferred revenue plays a crucial role in accounting. Why?
Because it represents unearned income. Put another way, it signifies advanced payments received for goods and services that have yet to be delivered. It’s essential that this revenue is treated differently than recognized revenue (see below) since all the contractual promises have yet to be carried out, and the order could end up canceled (the revenue, therefore, refunded).
Deferred revenue impacts a company’s cash flow and serves as a reminder of its obligation to fulfill commitments. Moreover, temporarily delaying unearned revenue from being reported as income (until the goods/services have been provided) helps prevent a company from overstating its sales revenue and misleading investors.
Instead, because of this revenue classification, stakeholders can gain more insight into the stability of the business and its revenue streams via its financial statements.
Deferred vs. Recognized Revenue: What’s the Difference?
It’s important to clarify the distinctions between deferred revenue (also called unearned revenue) and recognized revenue. Both are critical concepts in accrual accounting that dictate the timing of income recognition in conjunction with the FASB’s ASC 606 revenue recognition guide.
As mentioned above, deferred revenue occurs when a company invoices or receives payment for goods or services it hasn’t yet delivered. This creates a liability on the balance sheet, representing an obligation to fulfill the promised products or services.
On the income statement, unearned revenue isn’t immediately recognized as revenue. Instead, it gradually moves to the income statement from the balance sheet over time as the company fulfills its obligation to deliver the product or service. This naturally impacts revenue recognition and defers income recognition until the services are provided or the goods are delivered.
Conversely, recognized revenue refers to income earned from delivering goods or services. It is immediately recorded on the income statement upon completing the service or delivery of goods.
This recognition impacts both the income statement and the balance sheet, where revenue contributes to the company’s top-line performance, affecting profitability, while the corresponding liabilities (deferred revenue) decrease as services are provided or goods are delivered and adjusted on the balance sheet accordingly.
All accounting teams should understand the difference between deferred and recognized revenue to accurately portray their company’s performance and financial health to others.
How Does Deferred Revenue Work?
It’s time to get into all the nitty-gritty details surrounding deferred revenue.
Here’s how it works: Revenue is only recognized once the related goods or services have been delivered rather than when cash payments are received. The deferred revenue is initially recorded as a liability on the seller’s balance sheet. It’s considered a liability because there’s always the chance that something will happen and the advance payment will have to be refunded.
Later, as the goods or services are provided to the customer, the deferred revenue is recognized on the income statement as it is earned.
For example, a company receiving annual subscription payments upfront for a service rendered over the year would record deferred revenues. Consider a software firm receiving $120,000 for a year-long subscription service. Initially, it would record deferred revenue in the full amount on its balance sheet as a liability.
As each month passes, $10,000 of the deferred revenue would be moved over and recognized as revenue on the income statement, reflecting the service provided for that period. By the year’s end, all $120,000 will be recognized as revenue upon delivering all the services stipulated in the subscription agreement.
Is Deferred Revenue a Liability?
Deferred revenue is just that—deferred (that is, delayed). This means it is initially classified as a liability on the balance sheet until the obligation is fulfilled. Only at that point can the payment (or a portion of it) be recorded as revenue on the income statement.
Misclassifying and mismanaging revenue will lead to financial misrepresentation and inaccurate reporting, negatively impacting decision-makers and investors. Also, incorrectly classified revenue can also affect how a company manages its cash flow.
For more on how RightRev handles deferred revenue, check out our video:
How to Recognize Deferred Revenue (or How to Know When)
How and when do you practically apply the concept of deferred revenue? First, a company should identify contracts where customers pay for future deliveries or services in advance. Noting these particular contracts so transactions are documented correctly will help a business comply with accounting standards like ASC 606.
It’s also wise to identify and assess the performance obligations within these contracts, determine their completion statuses, and estimate the proportion of revenue that can be recognized based on completion. Monitoring these obligations and ensuring they align with all delivery and service milestones is necessary to appropriately recognize revenue over time.
Red flags often arise when there’s a mismatch between a cash payment and revenue recognition, indicating potential deferred income. A sudden spike in deferred revenue without corresponding performance obligations could signal errors in accounting or misinterpretation of contract terms. Furthermore, consistent reliance on deferred revenue to inflate net income might suggest unsustainable business practices, potentially misleading stakeholders.
Recognizing deferred revenue correctly demands diligence in aligning cash inflows with actual service or product deliveries to avoid premature recognition that could misrepresent financial health. Proper recognition ensures transparency, upholding the integrity of financial statements and fostering trust among investors and stakeholders.
Recognizing Deferred Revenue Correctly Is Critical
On its face value, revenue recognition seems pretty easy to understand: recognize revenue once it’s been earned rather than when it was received.
Okay. But what if a company receives payments from its customers prior to delivering its goods or services? This is where deferred revenue comes in, and things can get a bit more complicated.
It’s crucial that a company’s accounting team have a firm grasp on how to correctly classify revenue or else risk inaccurately portraying its performance to investors, regulators, and other stakeholders. Improperly recognizing deferred revenue can lead to overstated financial health and inflated profitability. Moreover, misclassifying revenue often triggers legal and regulatory issues, causing damage to the company’s reputation and undermining stakeholders’ trust in it.
On the flip side, understanding how deferred revenue works and utilizing it correctly can help companies predict future cash flows and make other financial projections, shedding light on their long-term sustainability and growth potential.
In reality, proper recognition of deferred revenue isn’t merely an accounting requirement. It’s a fundamental aspect of ethical business practices, helping to ensure transparency, reliability, and accuracy in financial reporting. It facilitates informed decision-making and builds trust among stakeholders.
How RightRev Can Help
Accounting teams face a million different complexities and tedious processes on a daily basis. For every trial period, tiered pricing option, or discount the sales team puts in place to close the deal downstream, the folks in accounting are paying the price—mired in complications and compliance worries. On top of that are the inevitable errors accompanying hours upon hours of manual calculations.
RightRev simplifies the whole process with its advanced revenue automation solution. Erase any worry about accidentally misclassifying revenue—the RightRev team knows just how to handle deferred revenue and everything that comes with it. Move forward confidently, making data-driven decisions using RightRev’s helpful revenue waterfall reports and other invaluable tools, including our rules-based revenue recognition policies that allow you to define specific revenue treatment by product or scenario for the automation of revenue recognition, deferred revenue, as well as unplanned revenue.
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