What is Deferred Revenue and Why Does it Matter?

Introduction

Deferred revenue is an important term used by companies to measure their financial performance. It is an advance from a customer prior to delivering a product or service that is recognized as revenue when the product or service is delivered. In other words, revenue earned and recorded upfront is recognized for revenue in the future when the product or service is delivered. Understanding deferred revenue is key to understanding a company's financial performance.

The importance of deferred revenue to a company's financial results is twofold. First, it helps a company to track its revenue accurately. By tracking how much revenue is deferred, a company can more accurately report its financial performance. Second, it helps a company to measure the impact of its product or service on its customers. By tracking how much revenue is deferred, a company can gauge how successful its product or service is in dealing with customer needs.

Types of Deferred Revenue

Deferred revenue, also referred to as unearned revenue, is money received for goods or services that have not yet been delivered. It does not recognize revenue at the time it is received, but rather when it is earned. There are two types of deferred revenue: Recognized Deferred Revenue and Unrecognized Deferred Revenue.

Recognized Deferred Revenue

Recognized Deferred Revenue is revenue that is booked on the balance sheet. It is a type of liability that appears on the balance sheet until the associated goods or services are delivered and turned into revenue. Examples of recognized deferred revenue include annual subscriptions, prepaid annual fees, and deposits.

Unrecognized Deferred Revenue

Unrecognized Deferred Revenue is money that has not been earned and therefore cannot be recorded. It is a contractual agreement that has not been fulfilled yet and is not classified as a liability or a revenue until the goods and services are delivered. Examples of unrecognized deferred revenue include short-term subscriptions, deposits on services, and deposits for merchandise returns.

Why Deferred Revenue is Important

Deferred revenue is an important part of a business's financials and plays an important role in accurately recognizing revenue, maintaining cash flow, and planning for the future.

Recognizing Revenue Accurately

Deferred revenues are a part of any business's financial statement, and they have a great impact on recognizing revenue. A deferred revenue situation occurs when a customer pays for a service or product that the business has not yet delivered. In this situation, the income on the business's income statement must accurately account for the economic event.

In the example of a customer being charged for a product or service prior to it being delivered or received, the received funds from the customer must be recorded in the books as a liability as opposed to revenue. This is done through the accounting practice of deferred revenue. This will ensure that the incurred liability for the product or service that has not yet been delivered is accounted for.

Maintaining Cash Flow

Deferred revenue can also be used to manage a business's cash flow. When funds are received up front but the services or products are not yet delivered, the business can use the deferred revenue to manage cash flow. The funds that have been received and set aside to pay for services or product can be used to manage cash flow in the meantime, minimizing the impact of cash fluctuations and ensuring that expenses are met.

Planning for the Future

A third advantage of managing deferred revenue is that it helps the business plan for the future. Because deferred revenue is a statement of liability, businesses can accurately track and record the funds that are owed. This means that businesses can plan for future expenses and know exactly how much money is available for future costs and investments.

Not only does deferred revenue help businesses plan for future expenses, it can also help them accurately assess their financial condition. As deferred revenue increases, businesses are more likely to have cash flow problems. Likewise, if deferred revenue decreases, this could be an indication that the business is experiencing improved cash flow.

What Creates Deferred Revenue?

Deferred revenue is any payment a company receives in advance of performing or providing a service or product. In other words, deferred revenue is cash the company holds that must be applied to earned revenue in the future. With deferred revenue, companies receive money in advance before they can recognize that money as actual revenue.

Long-term Contracts

One of the most common methods of creating deferred revenue is through long-term contracts. When companies sign contracts with customers to provide products or services over a long period of time, they often receive a payment upfront. This payment is recorded as deferred revenue because it must be recognized as sales revenue over the duration of the contract.

Gift Certificates or Subscriptions

Another common way to create deferred revenue is through gift certificates or subscription services. When companies sell gift certificates or subscriptions, customers often pay upfront for a period of time or an agreed-upon service or product. This advance payment is recognized as deferred revenue and must be recognized as actual revenue when customers use their gift certificates or services.

Sales-based Upfront Fees

In some cases, companies may also generate deferred revenue through the collection of sales-based upfront fees. For example, some companies may require customers to pay an upfront fee in order to secure a discount or purchase a promotional item. The upfront fee is recorded as deferred revenue and recognized as actual revenue when the customer makes a purchase.

Overall, deferred revenue is an important concept for businesses to understand as it is often a major source of revenue. Companies need to be able to accurately recognize deferred revenue and apply it to their sales revenue in order to accurately report their financial performance.

When Do You Record Deferred Revenue

Deferred revenue is revenue that has been received or billed, but has not yet been earned, due to goods and services not yet being delivered. Businesses use deferred revenue as a management tool to more precisely reflect the current financial composition of the company and to track behavior that would indicate future problems.

When a Customer Pays Upfront

When a customer pays upfront, but the service hasn't yet been delivered, the business must record the payment as deferred revenue on the balance sheet. This classification ensures the revenue is not wrongly reported as income.

When Services Begin

When services begin, and revenue starts to be earned, deferred revenue is no longer appropriate as the company has begun to provide services. The deferred amount should be moved from the balance sheet to the income statement.

The entry would be a debit to the revenue account and a credit to the deferred revenue account. The effect this has on the financial statements is a decrease in liabilities along with an increase in revenue.

When Is Deferred Revenue Recognized?

Deferred revenue is an accounting term used to refer to funds that have been collected from a customer, but not yet recognized as revenue for the business. Knowing when deferred revenue should be recognized is important for understanding the financial health of a company.

When Money Is Earned

The money is usually recognized when it is earned. This is typically after the customer has received the service or product they purchased, or in the case of subscription services, at the beginning of the subscription period. This is the most common approach to recognizing revenue.

When Services Are Completed

In some cases, businesses may want to recognize revenue until after all services related to the sale are completed. This usually applies to long-term contracts where multiple services are provided. This approach would recognize the revenue in installments as each service is completed.

Conclusion

In summary, deferred revenue is a type of accounting practice whereby revenue is recorded on your books before it has been earned. This practice is important to track accurately because it allows a business to fairly assess their fiscal position and to adjust their accounting books according to meticulous standards.

Generally deferred revenue is recorded on the balance sheet as a liability. It is recorded as such because the company is obliged to provide goods and services to the customer in exchange for the cash they received. As the company fulfills the services, the liability is recognized and the proceeds get moved to the income statement.

Summary of Definitions and Benefits

Deferred revenue is a type of accounting practice that allows businesses to properly track their receivables. It is an important practice because it allows accurate evaluation of the company’s fiscal position and it allows for proper adjustment of the accounting books accordingly.

Recap of When to Record and Recognize Deferred Revenue

It is important to understand when deferred revenue should be recorded on the books. Generally, deferred revenue is recorded when the customer pays in advance for goods or services that have yet to be delivered, or when a product or service has been provided to a customer but the customer has not yet made payment.

It is also important to recognize when deferred revenue is recognized as income. Generally, it is recognized after the company has fulfilled the services it has been contracted to provide. At that point, the liability is removed from the balance sheet and the proceeds are moved to the income statement.

In conclusion, deferred revenue is an important accounting practice that all businesses should consider in order to properly track and assess their fiscal position.