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Deferred Revenue

What is Deferred Revenue?

Deferred revenue, sometimes called unearned revenue or deferred income, represents revenue that has been received but has not yet been earned. It appears as a liability on a company’s balance sheet.

Deferred revenue occurs when a company receives payment from a customer for products or services that will be provided in the future.

What are Examples of Deferred Revenue?

Some common examples of deferred revenue include:

  • Subscription services: Companies that offer subscription-based services, such as software-as-a-service (SaaS), oftentimes receive payment upfront for service. This can include payment upfront for a year’s worth of service. Until the service is actually provided over the course of that year, the revenue is considered deferred.

  • Magazine subscriptions: Publishers typically receive payments for magazine subscriptions before the issues are delivered to subscribers. The revenue from these subscriptions is deferred until each issue is delivered.

  • Gift cards: When a customer purchases a gift card, the money received by the retailer is considered deferred revenue until the cardholder makes a purchase.

  • Customer deposits: In industries like real estate or construction, companies may receive deposits from customers before commencing a project. These deposits are recorded as deferred revenue until the work is completed.

How Do You Calculate Deferred Revenue?

The formula for calculating deferred revenue can be expressed as:

Deferred Revenue = Total Amount Received / Number of Recognition Periods

To calculate deferred revenue, you can follow these steps:

  1. Identify the Amount Received: Determine the total amount of money the company has received in advance from customers. This is the amount collected but not yet recognized as revenue.

  2. Determine the Recognition Period: Decide over which period or duration this deferred revenue will be recognized.

  3. Recognize Revenue Over Time: Divide the total amount received in advance by the number of periods in which the revenue will be recognized.

An example would be a company received $24,000 in advance for a two-year software subscription service. It would recognize this deferred revenue evenly over the two-year period.

Revenue
Time Period
$24,000
2 Year Subscription

Using the formula and chart above, we can calculate the deferred revenue.

Deferred Revenue = $24,000 / 2 years = $12,000 per year

This means that at the end of each year, it would recognize $12,000 as revenue from the deferred revenue account.

Is Deferred Revenue an Asset or Liability?

Deferred revenue is a liability, not an asset. It represents money received by a company in advance for goods or services that have not yet been provided or earned. When a company receives payment for products or services before delivering them, it creates a liability on its balance sheet called “deferred revenue.”

Here’s why deferred revenue is considered a liability:

  • Obligation to Perform: When a company receives payment in advance, it incurs an obligation to deliver the promised goods or services in the future. Until these obligations are fulfilled, the unearned revenue is considered a liability.

  • Timing of Recognition: Revenue recognition in accounting generally follows the principle of recognizing revenue when it is earned and realized, not when cash is received. Since the company has not yet provided the goods or services associated with the payment, it cannot recognize this cash as revenue but instead records it as a liability.

  • Balance Sheet Treatment: On the balance sheet, deferred revenue is listed under current liabilities because it represents a short-term obligation. As the company fulfills its obligations over time, the deferred revenue is gradually recognized as revenue on the income statement.

As the company delivers the products or services or meets its obligations over time, the deferred revenue is gradually reclassified from a liability to revenue on the income statement. This process reflects the conversion of the unearned revenue into earned revenue as the goods or services are provided.

How Do You Record Deferred Revenue on a Balance Sheet?

To record deferred revenue on a balance sheet, follow these steps:

  1. Identify Deferred Revenue Amount: Determine the amount of unearned or deferred revenue that needs to be recorded. This is the amount of money received from customers in advance for goods or services that have not yet been provided.

  2. Create an Unearned Revenue Liability Account: On the liabilities side of the balance sheet, create or locate an account specifically for deferred revenue. This account is often labeled “Unearned Revenue” or “Deferred Revenue.”

  3. Record the Deferred Revenue: Debit the Unearned Revenue account to increase it. This represents the money received but not yet earned as revenue.

  4. Match with a Corresponding Entry: The corresponding entry to the debit in the Unearned Revenue account is a credit to another account. The credit should typically be recorded in a revenue account that is appropriate for the type of revenue expected to be earned over time. For example, if a company offers subscription services, it can credit the “Subscription Revenue” account.

  5. Specify the Time Period: In the balance sheet or accounting records, specify the time period over which it is expected  to recognize the deferred revenue. For example, if a company received a payment for a one-year subscription service, it would typically plan to recognize the deferred revenue over the course of that year.

  6. Update Periodically: As time passes and the business provides the goods or services, it will “recognize” the deferred revenue as earned revenue on the income statement. To do this, the company will debit the revenue account and credit the deferred revenue account for the amount that corresponds to the period in question.

Here’s an example:

Suppose a company receives $12,000 for an annual software subscription. To record this on the balance sheet:

Identify the deferred revenue amount: $12,000.

Create or locate an “Unearned Revenue” account on the balance sheet’s liability side.

Debit the “Unearned Revenue” account with $12,000.

Credit the “Subscription Revenue” account (or a similar revenue account) with $12,000 to match the debit.

Over the course of the year, the company would gradually recognize the deferred revenue by debiting the “Subscription Revenue” account and crediting the “Unearned Revenue” account as it provides the software services each month. This process reflects the conversion of deferred revenue into earned revenue as you fulfill your obligations to the customer.

6 Steps to Record Deferred Revenue

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