Occasionally, a business will receive money upfront for goods or services that have yet to be delivered to a customer. In accrual accounting, revenue can only be recognised on the income statement when it has been earned. As such, any money received in advance is recorded on the balance sheet as deferred revenue (sometimes called unearned revenue).

So, how does this line item work exactly? And what does it tell investors?

What is deferred revenue? 

As previously stated, deferred revenue is recorded on a company’s balance sheet every time it receives money for goods or services that haven’t been delivered. This is very common among businesses with subscription and prepayment revenue models. Some prime examples include software-as-a-service (SaaS) companies and e-commerce enterprises (pre-orders for upcoming products).

The cash received from these transactions is technically in the company’s bank account. However, accrual accounting prevents it from being recognised as revenue on the income statement until the transaction is complete. Therefore a deferred revenue liability is recorded.

Why is deferred revenue a liability and not an asset? Because the company has an obligation to the customer to fulfil the order or issue a refund if that’s not possible. Typically, it’s marked down as a current liability since most orders are completed within a year. However, this line item may be marked down as a long-term liability for multi-year contracts.

This isn’t the case with revenue recognition in cash-based accounting, which records sales at the point of receiving cash flow. However, small and private businesses can only use this alternative technique. Any publically-traded corporation is required by law to use accrual accounting as it provides a more transparent and realistic reflection of a firm’s earnings.

How does deferred revenue work?

The unearned revenue liability will remain on the balance sheet until the transaction is completed. If the order is fulfilled, revenue will be recognised. If the order is refunded, revenue will not be recognised.

However, this recognition process becomes a bit more complicated for services received over time rather than a product delivered at a single point in time, such as a pre-order or ticket sale.

Therefore, there is more than one way to recognise deferred revenue as sales.

• Percentage of Completion – This payment recognition can be used where milestones signify completion at different stages of a project. The company may recognise profit after completing agreed-upon milestones with the customer while the project is still ongoing.
• Completed Contract – Unearned revenue is not recognised as sales until the contract is 100% completed and all obligations are fully satisfied. 
• Sales Basis – This is most common with retail sales. Payment is recognised at the point the goods are sold or delivered by the company. 
• Cost Recoverability – In this method, the company does not record any revenue in a given contract until it recovers the cost it incurs to fulfil the contract.

What’s the difference between deferred revenue and deferred expense? 

A deferred expense is the opposite of deferred revenue. They are recognised when a company has paid in advance for a product or service it has yet to receive. This typically occurs when a company estimates the resources and cost of carrying out a project. And it then makes an advanced payment to suppliers in exchange for the future delivery of goods or services.

Unlike deferred revenue, deferred expenses are recorded on the balance sheet as an asset. And this asset will be depleted as the orders are fulfilled, much like the liability for unearned revenue. However, instead of recording sales, the firm will report an item of expenditure on the income statement.

The bottom line

Recording unearned revenue and deferred expenses provides a more accurate picture of a company’s financial position. It can also help investment analysts forecast the near-term revenue stream with a higher degree of accuracy.

Accepting prepayment for goods and services is advantageous for different types of businesses. For example, if a subscription service only charges customers at the end of the subscription, there’s a good chance customers will state they cannot pay, requiring debt collectors to get involved.

However, prepayment can also cause problems in times of inflation. The company may fail to predict fluctuations in inflation over time accurately. If it were to rise, the increased cost of production would likely squeeze profit margins on orders or could even make pre-orders unprofitable.

This article contains general educational information only. It does not take into account the personal financial situation of the reader. Tax treatment is dependent on individual circumstances that may change in the future, and this article does not constitute any form of tax advice. Before committing to any investment decision, an investor must consider their individual financial circumstances and reach out to an independent financial advisor if necessary.