What is unearned revenue?
What is deferred revenue?
Many businesses, like online stores and music streaming platforms, rely on taking prepayments from customers before they have delivered any goods or services.
This is a perfectly valid business model, but it does have implications for how you record revenue in your accounting. The key thing for businesses to know is that, until your customer receives what’s owed to them, the money they’ve paid to you is known as deferred revenue.
In this article, we’ll explain how deferred revenue works, how to record it in your accounting, examples of deferred revenue in business, and how it differs from accrued revenue.
How does deferred revenue work?
Deferred revenue, also known as unearned revenue, refers to any payment you receive from your customers for goods or services that you have yet to provide.
Until you fulfill your obligation to deliver the products or services, this revenue is recorded as a liability on your company balance sheet, because there is still a chance that the order will be canceled or the goods will not be delivered. Afterwards, it becomes earned revenue on your income statement.
This change in status from deferred to earned revenue typically occurs proportionally as the goods or services are delivered.
For example, your customer might pay an up front fee of $120 in exchange for a year of access to your video streaming service. As each month elapses, $10 of the total would turn into earned revenue, while the rest would remain as deferred revenue. So, by month six, you would have $60 of earned revenue and $60 of deferred revenue.
Incorrectly categorizing deferred revenue as earned revenue by recording it on your income statement before you’ve fulfilled your obligations to your customer is considered aggressive accounting.
Is deferred revenue a liability?
Yes, deferred revenue is considered a liability on a company's balance sheet. It represents an obligation to deliver products or services in the future, since you have received payment upfront but have not yet earned the revenue. A liability is essentially a debt. In this case, the debt you owe is the provision of goods or services to your customer.
How is deferred revenue recorded?
Here’s how to account deferred revenue by recording it properly on your balance sheet. As stated earlier, you should record your deferred revenue as a liability, not an asset.
In cases where your prepayment terms are 12 months or less, you should record your deferred revenue as a current liability. However, if your customer has signed and prepaid for a multi-year contract, any revenue due to be earned for the provision of goods or services after the first year should be categorized as a long-term liability.
Let’s go into more detail using the earlier example of our video streaming service.
The customer makes a prepayment of $120 for a year of access to your platform. On your balance sheet, you will record:
- A debit entry for $120 in your cash (asset) account, as you have increased the amount of cash in your business
- A credit entry to your deferred revenue account for the same amount
As the year progresses, and your customer consumes another month of content, a proportion of your deferred revenue will become earned revenue, and you’ll need to adjust your balance sheet accordingly by:
- Debiting $10 from your deferred revenue account every month
- And crediting $10 to your revenue account
By the end of the year, the balance for the prepayment in your deferred revenue account will be $0 and you will have recorded $120 of earned revenue in your revenue account.
How to calculate deferred revenue
To calculate deferred revenue, you simply need to add together the total value of advance payments in your deferred revenue account.
For example, if you have five customers who each pay $120 for one year, you will have $600 in deferred revenue. Each month, your deferred revenue will reduce as $50 is debited from your deferred revenue account and credited to your revenue account. You may also gain or lose customers over that period, which will change your deferred revenue.
Examples of deferred revenue
Deferred revenue is common for several types of business, including:
- Software subscription - a customer pays an upfront fee for a 12-month software subscription. The revenue is deferred and recognized over the subscription period
- Online newspaper subscription - a newspaper receives payment for a year's online access. The revenue is deferred until each month has elapsed
- Gift cards - when a customer purchases a gift card, the revenue is deferred until the recipient uses the amount stored on the card to buy products or services
- Ecommerce - when a customer orders something from an online store, the revenue is deferred until they receive their goods
- Insurance - insurance providers routinely receive an upfront payment from their customers for 12 months of protection, which would be recorded as deferred revenue until the end of the period
- Contractor - a contractor might take on a year of maintenance work for a company, record their fees as deferred revenue, and then gradually recognize it as earned revenue as they provide their services
Accrued revenue vs deferred revenue
Accrued revenue and deferred revenue are both accounting concepts, but they represent different situations:
- Accrued Revenue - accrued revenue is when a company provides goods or services to a customer but has not yet received payment for them. Accrued revenue is initially recorded as an asset. Once the payment is received, the asset account is decreased, and revenue is recognized. An example of accrued revenue might be an energy provider supplying electricity to a customer who settles their bill at a later date
- Deferred Revenue - deferred revenue is the opposite of accrued revenue, as the company has received payment before providing goods or services. The payment is recorded as a liability and recognized as revenue only when the products or services are delivered
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