What is ‘Deferred Revenue’
Deferred revenue, or unearned revenue, refers to advance payments for products or services that are to be delivered in the future. The recipient of such prepayment records unearned revenue as a liability on a balance sheet, because it refers to revenue that has not yet been earned, but 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.
BREAKING DOWN ‘Deferred Revenue’
Deferred revenue is recognized as an obligation on the balance sheet of a company that receives advance payment, because it owes its customers services or products. 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 newspapers subscriptions, annual prepayment for the use of software, and prepaid insurance.
As a company delivers services or products, deferred revenue is gradually recognized on the income statement. Analysts typically conduct a careful study of trends in deferred revenue accounts of companies with significant unearned revenues balances, to obtain a better indication of their financial performance. Recording unearned revenues on an income statement, rather than as deferred revenues on the balance sheet, may be considered as aggressive accounting, as it would have the effect of overstating revenues.
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 payment date must be classified as deferred revenue under the long-term liability section of the balance sheet.
Example of Accounting for Deferred Revenue
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 $120. By the end of the fiscal year, the entire deferred revenue balance of $1,200 is reversed and is booked as revenue on the income statement.