What is deferred revenue?  

Deferred revenue, also known as unearned revenue or advance payments, refers to the money that a company has received from its customers in advance for goods or services that are yet to be delivered or performed.   

In other words, deferred revenue represents a liability on the company’s balance sheet that reflects an obligation to provide goods or services to the customer at a later date. The revenue is deferred because it has yet to be earned, and it will be recognized as revenue only when the goods or services are delivered or performed.

Deferred revenue and accrued expenses  

Deferred revenue and accrued expenses are two types of accounting concepts that relate to when revenue and expenses are recognized on a company’s financial statements.  

Deferred revenue, also known as unearned revenue, is the revenue that has been received by a company in advance, for the goods or services being delivered to the customer. This can occur when a customer pays for a product or service in advance, but the delivery or completion of the product or service is delayed. The revenue is recorded as a liability on the company’s balance sheet until the goods or services are delivered, at which point it is recognized as revenue.  

Accrued expenses, on the other hand, are expenses that have been incurred by a company but have yet to be paid for. This can occur when a company receives a service or incurs an expense but has yet to receive an invoice or pay for it. The expense is recorded as a liability on the company’s balance sheet until it is paid, at which point it is recognized as an expense on the income statement.  

In both cases, the recognition of revenue or expense is deferred until the underlying transaction occurs. This ensures that the financial statements accurately reflect the timing of the transactions and the financial position of the company.  

How does deferred revenue work under cash and accrual accounting?  

Deferred revenue, also known as unearned revenue, is a liability that arises when a company receives payment for goods or services that it has not yet delivered or provided. The revenue is ‘deferred’ until the goods or services are delivered, at which point it is recognized as revenue.  

Under cash accounting, revenue is recognized when cash is received, regardless of when the goods or services are actually delivered. This means that if a company receives payment for a product or service in advance, the revenue will be recognized immediately and there will be no deferred revenue balance on the balance sheet.  

Under accrual accounting, revenue is recognized when it is earned, regardless of when cash is received. This means that if a company receives payment for a product or service in advance, the revenue will not be recognized until the goods or services are actually delivered. In the meantime, the payment received will be recorded as a liability, specifically as deferred revenue on the balance sheet. 

For example, suppose a company receives $1,000 in advance for a service that will be provided in the next quarter. Under accrual accounting, the company would record this as a liability on the balance sheet, specifically as deferred revenue. When the service is provided in the next quarter, the $1,000 would be recognized as revenue and the deferred revenue liability would be reduced to zero.  

Why is deferred revenue classified as a liability?  

Deferred revenue is classified as a liability because it represents an obligation that a company owes to its customers. It arises when a company receives payment from its customers for goods or services that it has yet to deliver. This means that the company has a responsibility to provide these goods or services to the customer at a later date, which creates a liability.  

To understand why deferred revenue is classified as a liability, consider the following example:  

– Let’s say a software company receives payment for a one-year subscription to its software product. The payment is made up front, but the company will provide access to the software over the course of the year. Since the company has yet to deliver the full product to the customer, it cannot recognize the revenue as earned. Instead, it records the payment as deferred revenue on the balance sheet, which is a liability.  

– Deferred revenue is recorded as a liability because it represents an obligation that the company must provide goods or services to its customers in the future. This means that the company has a responsibility to deliver the product or service that the customer has paid for. Until the company fulfills this obligation, the payment remains a liability.  

– The accounting treatment for deferred revenue is as follows. When the company fulfills its obligation and delivers the product or service to the customer, it recognizes the revenue as earned and reduces the deferred revenue liability on the balance sheet. This means that the revenue is recognized when the product or service is delivered rather than when the payment is received. This is known as the matching principle, which requires that expenses be matched with the revenue they generate.  

– The payment is recorded as deferred revenue on the balance sheet until the company fulfills its obligation and delivers the product or service to the customer, at which point the revenue is recognized and the deferred revenue liability is reduced.  

Conclusion  

In conclusion, deferred revenue refers to the income that a company receives in advance for goods or services that it has not yet provided to the customer. It is considered a liability because the company has an obligation to deliver the promised goods or services in the future. Until that obligation is fulfilled, the company cannot recognize the revenue as earned income on its financial statements. Instead, the company must report the deferred revenue as a liability, which represents the amount owed to the customer. By doing so, the company can accurately reflect its financial position and provide transparency to investors and other stakeholders. Understanding deferred revenue and its treatment as a liability is an important concept in accounting, as it impacts a company’s financial statements and affects its overall financial health. 

Also Read: What Is Tax Liability And How To Calculate

Farwah Jafri

Farwah Jafri is a financial management expert and Product Owner at Monily, where she leads financial services for small and medium businesses. With over a decade of experience, including a directorial role at Arthur Lawrence UK Ltd., she specializes in bookkeeping, payroll, and financial analytics. Farwah holds an MBA from Alliance Manchester Business School and a BS in Computer Software Engineering. Based in Houston, Texas, she is dedicated to helping businesses better their financial operations.