A Guide to Calculating Deferred Revenue

Introduction

Deferred revenue, also known as unearned revenue, is a type of liability that represents a company's receipt of payment before it is fully earned. It can arise when a company sells goods or services on a subscription/contract basis and it isn’t yet due to be received. Accurately calculating deferred revenue is important as it is used to gauge a company’s financial health and future growth potential.

What is Deferred Revenue?

Deferred revenue is an advance payment a company receives for goods or services yet to be provided to the customer. The payment is recorded as a liability until it is earned according to the terms of the sale or the delivery of the goods/services.

Examples of Deferred Revenue

• Companies that operate subscription-based [business models] are more likely to record Deferred Revenue
• When companies receive payments for goods that have not been delivered yet
• Payment for services that have not been performed yet
• Advance payments of annual membership fees
• Down payments on long-term contracts

Steps For Calculating Deferred Revenue

Calculating deferred revenue helps businesses track and account for income received but not yet recognized. In order to properly calculate deferred revenue, businesses must complete several steps.

Identify the Services Rendered

Firstly, businesses must determine the services they rendered customers in exchange for goods and services received in the future. Depending on the industry, goods and services received can include sales of subscription software, products, services and goods, research conducted and events hosted.

Calculate the Related Revenue

Once the goods and services are identified, businesses must calculate the total amount of revenue associated with each transaction. To calculate the revenue associated with goods and services, businesses should start with the invoice or contract value and subtract any accounts receivable adjustments.

Allocate Revenue to the Accounting Period

Finally, businesses must allocate the revenue among several accounting periods. A commonly accepted approach for allocating revenue is on a straight-line method, which involves dividing the total revenue by the total number of periods covered by the agreement.

By following these steps, businesses can ensure they accurately calculate deferred revenue and recognize the related income on the right accounting periods.

Benefits of Deferred Revenue

Deferred revenue occurs when a company receives payment for goods/services without having delivered the service/goods yet. This type of accounting treatment helps by providing businesses with future projections regarding their revenues. Companies can use this information to plan for future business activities ranging from product launches, to research and development and beyond. There are two key benefits of deferred revenue which will be discussed below.

Businesses Can Plan for Future Revenues

Calculating deferred revenue helps organizations focus on their current financial commitments and build long-term plans based on more precise earnings projections. By taking into account fees that have already been received but that have yet to be earned, organizations can accurately assess current and future cash flow. This can be especially vital in industries that have exceptionally seasonal revenues such as the hospitality and travel industry.

Smoothing of Seasonal Revenues

In addition to helping organizations plan for future revenues, deferred revenue can also have the benefit of smoothing out seasonal revenues. By allocating revenue over multiple periods, companies can avoid the peaks and valleys associated with extremely seasonal revenue. This can help organizations better manage resources and plan for future cash flow. It can also reduce the overall risk associated with highly seasonal revenues as organizations will now have a more reliable projection on which to base their plans.

Deferred revenue can be invaluable for organizations that receive income prior to delivering goods/services. Organizations that take into account deferred revenue can benefit from more accurate forecasting of future revenue streams which will help to drive their long-term planning.

Implications of Deferred Revenue

Deferred revenue can be a powerful tool for businesses when it comes to budgeting and keeping track of their financials. However, there are various implications of this revenue, which must be taken into consideration for accurate reporting.

Deferred Revenue Can Effect the Timing of Reported Revenues

When a company records a sale, the typical practice is to recognize the revenue at the time of transaction. With deferred revenue, the timing of recognizing the revenue can be moved to a future date. This means that the company will not book the revenue until a future period, which can have a significant effect on reported revenue for the current period. It is important for businesses to understand the potential implications of delaying the recognition of revenues.

Unfulfilled Contracts Can Create Potential Refunds

When a contract is established with deferred revenue, there is a certain level of trust that is assumed. This means that customers are expecting a product or service to be fulfilled at a later date. If the company is unable to fulfill the terms of the agreement, it can put them at risk of having to offer refunds to their customers. In the event that a refund is necessary, the deferred revenue that was originally booked will have to be reversed.

For businesses that use deferred revenue, it is important to keep track of unfulfilled contracts. Oftentimes, companies can adjust their revenue recognition policies to ensure that refunds will be accounted for in the period of sale, reducing the potential of having to reverse bookings that are already in the books.

5. Causes of Deferred Revenue

Deferred revenue occurs when money is received in advance by a company for goods or services that have yet to be provided as of its time of calculation. When calculating deferred revenue amounts, the company must take into consideration the total received and expected expenses associated with the services that have yet to be rendered. Common causes of deferred revenue include services not yet provided and advance payments.

a. Goods and Services Sold Before Payment for Billing Cycles

A common cause of deferred revenue is for goods or services sold prior to the payment of the associated billing cycle. For example, a company may accept payment up front for a periodic service like website hosting, but the billing cycle for the services is set to begin in the future. The company must then must recognize the total amount of the advance payment for services and factor in the periods for which the services have yet to be provided. In this case, the company should set up a deferred revenue balance to reflect the amount yet to be provided.

b. Seasonal Purchases Before Fulfillment of Services

Another common example of deferred revenue is when customers purchase goods or services prior to their fulfillment. For example, if a customer purchases a service that is to be fulfilled during a particular season, the total payment must be recognized at the time of purchase, and the associated revenue is deferred until the service is eventually rendered. This can be a tricky process to calculate, as the deferred revenue recognition must factor in the periods during which services are rendered, as well as any expected costs associated with their delivery.

Common Practice for Deferred Revenue

Deferred revenue is an accounting concept for recognizing future earned revenue in the present. Companies can handle deferred revenue in different ways - what matters most is that the practice is consistent across the business. To get an idea of the most common practices for deferred revenue, this guide outlines two options: billing customers upfront and allowing payment terms.

Billing Customers Upfront

The easiest way to ensure deferred revenue is handled accurately, is to bill customers upfront. This means that customers pay in full before any services, products, or subscriptions are provided. This ensures both parties agree on the amount due and that no future revenue is left unaccounted for. This is often helpful with subscription-based services, such as yearly software licenses or magazine subscriptions.

Allowing Payment Terms

Another popular practice for deferred revenue is allowing customers to pay over time. This is called creating payment terms. Instead of requiring payment upfront, customers can pay in installments over a set time period. This method can be beneficial for larger purchases, as customers are able to spread out their payments. To account for this practice, companies should be sure to adjust their balance sheet each month to reflect deferred revenue.

Payment terms are just one way companies can account for deferred revenue and ensure accurate records. While this guide may give you a better understanding of common practices and how they can be applied to your business, it’s important to review all financial obstacles from an accountant to ensure accurate data.

Conclusion

Deferred revenue is an important concept in accounting and finance, and it is important to understand the process of calculating it. This guide has provided an overview of the steps involved in calculating deferred revenue.

Summary of Steps for Calculating Deferred Revenue

• Estimate the initial deferred revenue amount.
• Identify the applicable rate for deferred revenue.
• Update deferred revenue as revenue comes in.
• Account for deferred revenue in financial statements.

Overview of Benefits and Implications

Calculating deferred revenue can provide companies with valuable insights into their cash flow and operational performance. It can also provide analysts with a better understanding of the long-term effects of revenue recognition. Additionally, understanding deferred revenue can help companies save money through effective cash management and tax planning.