What is Deferred Revenue?
Deferred Revenue (also called Unearned Revenue) is generated when a company receives payment for goods and/or services that it has not yet earned. In accrual accounting, revenue is only recognized when it is earned. If a customer pays for good/services in advance, the company does not record any revenue on its income statement and instead records a liability on its balance sheet.
Example of deferred revenue
Let’s look at a detailed example of the accounting entries a company would make when deferred revenue is created and then depleted.
On August 1, Cloud Storage Co received a $1,200 payment for a one-year contract from a new client. Since the services are to be expensed over a year, the company must take a year to earn the revenue and divide it into monthly amounts of $100.
On August 1, the company would record a revenue of $0 on the income statement. On the balance sheet, cash would increase by $1,200 and a liability called deferred revenue of $1,200 would be created.
On September 1, the company would record a revenue of $100 on the income statement. On the balance sheet, cash would be the unaffected and the deferred revenue liability would reduce to $1,100 while net income of $100 would be added to retained earnings in shareholders’ equity.
The pattern would repeat each month until the end of 12 months when total revenue recognized over the period is $1,200, retained earnings are $1,200 and cash is $1,200. At that point, the deferred revenue from the transaction is now $0.
Download CFI’s deferred revenue template to analyze the numbers on your own.
Why companies record deferred revenue
The simple answer is that they are required to, due to the accounting principles of revenue recognition. Just as expenses are accrued and smoothed out over time, so are revenues.
The timing of payments from customers can be volatile and unpredictable, so it makes sense to ignore the timing of the cash payment and recognize revenue when it is earned.
Cash from operating activities
We’ve seen what happens to the income statement and balance sheet. Now, let’s look at the impact on the cash flow statement.
Referring to the example above, on August 1, when the company’s net income is $0, it would see an increase in current liabilities of $1,200, which would result in cash from operating activities of $1,200.
In all subsequent months, cash from operations would be $0 as each $100 increment in net income would be offset by a corresponding $100 decrease in current liabilities (the deferred revenue account).
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