What Is Deferred Revenue?
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. The company that receives the prepayment records the amount as unearned revenue on its balance sheet as a liability. Deferred revenue is a liability because it refers to revenue that has not been earned and represents products or services that are owed to a customer. As the product or service is delivered over time, it is recognized as revenue on the income statement.
How Deferred Revenue Works
Deferred revenue is recognized as an obligation on the balance sheet of a company that receives the advance payment because it owes the customer products or services. The payment is considered a liability because there is still the possibility that the good or service may not be delivered, or the buyer might cancel the order. In either case, the company would repay the customer, unless other payment terms were explicitly stated in a signed contract. Contracts can stipulate different terms, whereby it's possible that no revenue may be recorded until all of the services or products have been delivered. In other words, the payments collected from the customer would remain in deferred revenue until the customer has received what was due according to the contract.
As a company delivers services or products, deferred revenue is gradually recognized on the income statement as the revenue is "earned." Categorizing deferred revenue as earned revenue too soon, or simply bypassing the deferred revenue account and posting it directly as revenue on the income statement, is considered aggressive accounting and effectively overstates sales.
Deferred revenue is common with 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.
Reporting of Deferred Revenue
Deferred revenue is typically disclosed as a current liability on a company's balance sheet. However, if a customer made an up-front prepayment for services that are expected to be delivered over several years, the portion of the payment that pertains to services or products to be provided after 12 months from the payment date should be classified as deferred revenue under the long-term liability section of the balance sheet.
Consider a media company that receives $1,200 in advance payment at the beginning of its fiscal year from a customer for an annual newspaper subscription. Upon receipt of the payment, the company's accountants record a debit entry to the cash and cash equivalent account, and a credit entry to the deferred revenue for $1,200.
As the fiscal year progresses, the company sends the newspapers to its customer and recognizes revenue each month by recording a debit entry to the deferred revenue account, and a credit entry to the revenue account for $1,200. By the end of the fiscal year, the entire deferred revenue balance of $1,200 has been gradually booked as revenue on the income statement.