Deferred revenue: Is it a liability & how to account for it?

ProfitWell Jul 15 2021

As per basic accounting principles, a business should not recognize income until it has earned it, and it should not recognize expenses until it has spent them.

For these purposes, accountants use the term deferral to refer to the act of delaying recognizing certain revenues (or even expenses) on your income statement over a specified period. Instead, you will record them on balance sheet accounts as liabilities (or assets for expenses) until you earn or use them. You will later move them in portions from your balance sheet accounts to revenues (or expenses) on your income statement.

The timing of customers' payments tends to be unpredictable and volatile, so it's prudent to ignore the timing of cash payments and only recognize revenue when you earn it.

Revenue recognition is one reason why the Financial Accounting Standards Board (FASB) issued the Generally Accepted Accounting Principles (GAAP). GAAP accounting metrics include detailed revenue recognition rules tailored to each industry and business type.

 

What is Deferred Revenue?

Deferred revenue refers to money you receive in advance for products you will supply or services you will perform in the future. For example, annual subscription payments you receive at the beginning of the year or rent payments you receive in advance. This deferred revenue definition implies a lag between purchase and delivery. Hence, you can also refer to it as unearned revenue.

For example, when a SaaS company charges a new client a $180 annual subscription fee, it does not immediately record the fee as actual revenue in its books. Instead, it will record it as deferred revenue first in its balance sheet and only record the $180 in revenue at the end of the year after earning the entire fee.

Deferred revenue vs. recognized revenue

Deferred revenue is the revenue you expect from a booking, but you are yet to deliver on the account's agreement. Thus, even though you received the revenue in your account, you cannot quite count it as revenue. Whereas recognized revenue refers to the point at which a booking or deferred revenue becomes actual revenue for your business after delivering on the agreement as promised. It goes into your account receivables.

Let's say you have a converted customer who makes a booking for your annual SaaS subscription services in January valued at $12,000 ($1000 per month). From a SaaS accounting perspective, you will not earn that revenue until you deliver what you sold to the customer. It means that the $12,000 deferred revenue turns into revenue gradually with each month as the subscription progresses. Thus, each month you recognize earning $1000 from the account.

Is deferred revenue a liability?

Technically, you cannot consider deferred revenues as revenue until you earn them—you deliver the products or services prepaid. Therefore, you cannot report these revenues on the income statement. Instead, you will report them on your balance sheet as a liability.

Just because you have received deferred revenue in your bank account does not mean your clients will not ask for a refund in the future. Additionally, some industries have strict rules governing how to treat deferred revenue. For example, the legal profession requires lawyers to deposit unearned fees into an IOLTA trust account to satisfy their fiduciary and ethical duty. The penalties for non-compliance can be harsh—sometimes leading to disbarment.

Deferred revenue examples

Deferred revenue is commonplace among subscription-based, recurring revenue businesses such as SaaS companies. When you receive money for a service or product you don't fulfill at the point of purchase, you cannot count it as real revenue but deferred revenue. Since it represents products or services you owe your customers, you will record it as a liability.

1. Deferred revenue in SaaS

Deferred revenue is expected among SaaS companies because they offer subscription-based products and services requiring pre-payments. For example, an annual subscription plan to a SaaS company.

Imagine a SaaS company offers a monthly plan with $10 payments and a discounted yearly plan of 99.99 to attract customers. The company will defer the revenue from customers who opt to pay in advance for the annual subscription to enjoy the discount and recognize it monthly as per the customers' use of the service.

2. Deferred revenue in retail

The retail industry also deals with deferred revenue in several instances, including:

  • Online orders where customers may pre-order goods of a particular value and await their delivery. For example, customers may order new designer clothes and shoes before a retailer releases them in the market.
  • Gift cards are another instance of deferred retail revenue where customers may purchase them in advance and opt to redeem them later.

How to account for deferred revenue

Businesses record deferred and recognized revenue because the principles of revenue recognition require them to do it. Accrual accounting classifies deferred revenue as a reverse prepaid expense (liability) since a business owes either the cash received or the service or product ordered.

In accrual accounting, you only recognize revenue when you earn it, unlike in cash accounting, where you only earn revenue when you receive a payment period. Therefore, under accrual accounting, if customers pay for products or services in advance, you cannot record any revenue on your income statement. Instead, you will record the payment as a liability on your balance sheet.

Let's say your company provides SaaS software via subscription to customers with a one-year plan you break down into monthly payments of $8.99. You will have customers who opt to make advance payments for the entire first year upon subscription valued at $107.88. You will defer this revenue until they receive a full year's use of the service. Therefore, your accounting team will recognize 1/12 of the $107.88 deferred income monthly because you have delivered that proportion of your service.

Recognize your deferred revenue with ProfitWell Recognized

Customer pre-payments are often unpredictable and volatile, hence the use of accrual accounting to keep track of your deferred revenue and prevent it from hamstringing your subscription business. Today, companies are turning to smarter approaches to revenue reporting and recognition, such as ProfitWell Recognized – an AI-oriented solution. Its benefits include:

1. Minimize human error for better accuracy

Human errors resulting from manual balance sheet entries are inevitable, but you can minimize them with ProfitWell's revenue recognition software. Deferred and recognized revenue for a business with a massive subscription customer base can mean thousands of lines in spreadsheets, all while ensuring you remain compliant with accounting standards. Recognition software does not get tired or bored. It's accurate, precise, and fast in its calculations.

2. Save time with a revenue recognition process

Revenue recognition software is efficient in saving time for many different departments other than accounting and finance. For example, sales representatives who use manual record entries to input customer information must take care and caution to input the correct information for proper revenue recognition.

When you have sales reps using 17% of their time on administrative tasks (for example, logging customer or sales information) instead of pursuing and converting leads, it affects your bottom line. Therefore, with the correct software in place, accountants and sales reps alike free up time to focus on other essential tasks.

3. Focus on analysis and revenue trends

ProfitWell Recognized is top-tier accounting software designed to make your revenue recognition process simpler. It helps you automate complicated revenue calculations and situations. For example, you can use the software to set standard controls, methods, and rules to recognize revenue in a specified way. Additionally, you can use it to automate amortization schedules and sort and analyze revenue by criteria.

Deferred revenue FAQs

Why is deferred revenue considered a liability?

Businesses and accountants record deferred revenue as a liability (a balance sheet credit entry) because it represents products and services you owe your customers—for example, an annual subscription for SaaS software, a retainer for legal services, or a hotel booking fee.

What is the difference between deferred revenue and unearned revenue?

There is no difference between unearned revenue and deferred revenue because they both refer to advance payments a business receives for its products or services it's yet to deliver or perform. Thus, they are items on a balance sheet you initially enter as a liability (an obligation to fulfill in the future) but later become an asset.

Is deferred revenue a good or bad thing?

Deferred revenue is neither a good nor a bad thing. So perhaps the correct answer would be that it depends—mostly on a business's revenue recognition tracking systems that correctly track and assign pre-payments as either deferred (unearned) revenue or recognized revenue.

Is deferred revenue a debit or credit in accounting?

Since deferred revenue is a liability until you deliver the products or services per the booking agreement, you will make an initial credit entry on the right side of the balance sheet under current liability (if the sale is under 12 months) or long-term liability. Then, as you earn revenue over time, you will debit the deferred revenue account and credit the revenue account.

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