Deferred Revenue

What is the Definition of Deferred Revenue?

Deferred revenue—or “unearned revenue”—arises if a customer pays upfront for a product or service that has not yet been delivered by the company.

Under accrual accounting, the timing of revenue recognition and when revenue is considered “earned” depends on when the product or service is delivered to the customer.

Therefore, if a company collects payments for products or services not actually delivered, the payment received cannot yet be counted as revenue.

During the time lag between the date of initial payment and delivery of the product or service to the customer, the payment is instead recorded on the balance sheet as “Deferred Revenue”.

Deferred revenue is classified as a liability on the balance sheet, and represents the cash collected prior to the customer receiving the products or services.

Deferred Revenue: Examples in Business

For a transaction to be recognized as deferred revenue, the payment must be received in advance, so the benefit to the customer is expected to be delivered later.

Gradually, as the product or service is delivered to the customers over time, the deferred revenue is recognized proportionally on the income statement.

Common Examples

• Unused Gift Cards
• Subscription Plans (e.g. Annual Newspaper Subscription Plan)
• Service Agreements Associated with Product Purchase
• Implied Rights to Future Software Upgrades
• Upfront Insurance Premium Payments

Is Deferred Revenue a Liability?

Following the standards established by U.S. GAAP, deferred revenue is treated as a liability on the balance sheet, since the revenue recognition requirements are incomplete.

Typically, deferred revenue is listed as a current liability on the balance sheet due to prepayment terms ordinarily lasting fewer than twelve months.

However, if the business model requires customers to make payments in advance for several years, the portion to be delivered beyond the initial twelve months is classified as a “non-current” liability.

A future transaction has numerous unpredictable variables, so as a conservative measure, revenue is recognized only once actually earned (i.e. the product/service is delivered).

The payment received from the customer receives treatment as a liability because of:

• The company’s remaining obligations are to provide the products/services to customers.
• The chance that the product/service is not delivered as originally planned (i.e. an unexpected event).
• The potential inclusion of clauses in the contract that allow the cancellation of the order.

In all the scenarios above, the company must repay the customer for the prepayment.

Another consideration is that once the revenue is recognized, the payment will now flow down the income statement and be taxed in the appropriate period in which the product/service was actually delivered.

Deferred Revenue vs. Accounts Receivable: What is the Difference?

The difference between deferred revenue and accounts receivable is as follows.

• Deferred Revenue → Unlike accounts receivable (A/R), deferred revenue is classified as a liability, since the company received cash payments upfront and has unfulfilled obligations to its customers.
• Accounts Receivable → In contrast, accounts receivable (A/R) is essentially the opposite of deferred revenue, as the company has already delivered the products/services to the customer who paid on credit. For accounts receivable, the only remaining step is the collection of cash payments by the company once the customer fulfills their end of the transaction — hence, the classification of A/R as a current asset.

Deferred Revenue Calculation Example

Suppose a company sells a laptop to a customer at a price tag of $1,000.

Of the $1,000 sale price, we’ll assume $850 of the sale is allocated to the laptop sale, while the remaining $50 is attributable to the customer’s contractual right to future software upgrades.

In total, the company collects the entire $1,000 in cash, but only $850 is recognized as revenue on the income statement.

• Total Cash Payment = $1,000
• Revenue Recognized = $850
• Deferred Revenue = $150

The remaining $150 sits on the balance sheet as deferred revenue until the software upgrades are fully delivered to the customer by the company.

Deferred Revenue Journal Entry Example (Debit or Credit)

Suppose a manufacturing company receives $10,000 payment for services that have not yet been delivered.

The initial journal entry will be a debit to the cash account and credit to the unearned revenue account.

• Cash Account ➝ Debit
• Unearned Revenue Account ➝ Credit

Once the services are delivered to the customer, the revenue can be recognized with the following journal entry, where the liability decreases while the revenue increases.

• Unearned Revenue Account ➝ Debit
• Revenue Account ➝ Credit

Since the revenue is now considered to be “earned” per accrual accounting guidelines, the income statement will recognize the value of the customer payments as revenue.

On the balance sheet, the deferred revenue balance will reduce accordingly based on the revenue recognized.