Deferred Revenue vs. Accrued Expense: An Overview
Deferred revenue, also known as unearned revenue, refers to advance payments a company receives for products or services that are to be delivered or performed in the future. Accrued expenses refer to expenses that are recognized on the books before they have actually been paid.
As an example, SaaS (software-as-a-service) businesses that sell pre-paid subscriptions with services rendered over time will defer revenue over the life of the contract and use accrual accounting to demonstrate how the company is doing over the longer term. This approach helps highlight how much sales are contributing to long-term growth and profitability.
- Deferred revenue is the portion of a company's revenue that has not been earned, but cash has been collected from customers in the form of prepayment.
- Accrued expenses are the expenses of a company that have been incurred but not yet paid.
- Pre-paid subscriptions with services rendered over time will defer revenue over the life of the contract and use accrual accounting to demonstrate how the company is doing over the longer term.
Deferred revenue is an obligation on a company's balance sheet that receives the advance payment because it owes the customer products or services.
Deferred revenue is most common among companies selling subscription-based products or services that require prepayments.
Examples of unearned revenue are rent payments made in advance, prepayment for newspaper subscriptions, annual prepayment for the use of software, and prepaid insurance.
In the case of a prepayment, a company's goods or services will be delivered or performed in a future period. The prepayment is recognized as a liability on the balance sheet in the form of deferred revenue. When the good or service is delivered or performed, the deferred revenue becomes earned revenue and moves from the balance sheet to the income statement.
Under the revenue recognition principles of accrual accounting, revenue can only be recorded as earned in a period when all goods and services have been performed or delivered. If a company's goods or services have not been performed or delivered, but a customer has paid for a future service or a future good, the revenue from that purchase can only be recorded as revenue in the period in which the good or service is performed or delivered.
Under the expense recognition principles of accrual accounting, expenses are recorded in the period in which they were incurred and not paid. If a company incurs an expense in one period but will not pay the expense until the following period, the expense is recorded as a liability on the company's balance sheet in the form of an accrued expense. When the expense is paid, it reduces the accrued expense account on the balance sheet and also reduces the cash account on the balance sheet by the same amount. The expense is already reflected in the income statement in the period in which it was incurred.
For example, a software company signs a customer to a three-year service contract for $48,000 per year, and the customer pays the company $48,000 upfront on January 1st for the maintenance service for the entire year.
After receiving payment, the company will debit cash for $48,000 and credit (increase) the deferred revenue account for $48,000. As time passes and services are rendered, the company should debit the deferred revenue account and post a credit to the revenue account. For instance, on February 1st, the company should recognize $4,000 as a credit in the revenue account ($48,000/12 = $4,000) and debit $4,000 in the deferred revenue account to show that services have been performed and revenue has been recognized for the period from January 1st to January 31st.