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Join nowIt can minimize tax liabilities and improve financial accuracy, forecasting, and risk management.
By Naveen Gabrani, Founder and CEO, Astrea IT Services
We all want to get paid — and getting paid upfront sounds ideal. With money already in your pocket from an early payment, you may feel like you can count on the business to keep coming. But any money received before you've earned it, known as deferred revenue, is considered an accounting liability — one that can be quite complex to manage at scale.
In this article, we'll unpack why that is and how you can properly account for deferred revenue.
Deferred revenue refers to funds or payment a company receives in advance for products or services that have yet to be delivered. This is also commonly referred to as "unearned revenue." Revenue is only "earned" once you've delivered what you've promised to your customers.
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Some revenue models routinely take on this liability, given the nature of their business. Other businesses may have multiple revenue streams, some of which include revenue deferral. Common examples include:
From an accounting perspective, deferred revenue is considered a liability until the products or services that have already been paid for are delivered. That means that these products and services are not reported on your company's income statement, and it's important that this revenue is categorized as "unearned" to accurately reflect your financial status.
As an illustration, let's consider a hypothetical baking school named Wonderful Cakes Academy (WCA). A baking course at WCA includes 12 sessions over a period of six months, with two classes each month priced at $100 per class. The course runs from July to December, and WCA collects payments from students in June. This situation exemplifies deferred revenue, as full payment is received the month prior to when the classes begin.
So, when a student pays $1,200 in June, WCA records this as a $1,200 debit to cash and a $1,200 credit to deferred revenue. This amount signifies a liability for WCA since the services have not yet been rendered. As the income is earned, however, the liability is reduced and is recognized as revenue.
From an accounting perspective, WCA will recognize one-sixth of the deferred revenue as earned revenue each month, corresponding to the completion of two training sessions per month. By the end of December, once the course is finished, WCS will classify the entire $1,200 payment (per student) as income, because the services have now been fulfilled.
Complying with accounting standards and accurately recognizing revenue requires that a business's income statement only recognizes revenue when it is earned, and deferred revenue is only recognized as earned once the goods or services are delivered to the customer.
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Organizations must acknowledge that deferred revenue signifies incomplete work. To effectively manage tax liabilities and financial forecasting, it's crucial to keep accounting teams informed about the status of deferred revenue payments and the timeline for service delivery. This is because accounting teams need to:
Deferred revenue can impact a company's valuation, and it must be tracked to meet compliance standards.
To mitigate risk, accounting teams should aim to allocate the payments received from deferred revenue toward the expenses associated with the services yet to be delivered. Keeping with the above example, the $1,200 received from each student for the six-month baking course at WCA might be allocated toward the instructor's salary and the baking supplies or ingredients needed for each session. Spending it too soon on something like a new oven or an unrelated goal amplifies financial risk.
Beyond due diligence and meeting compliance standards, there are several important benefits of effectively managing and reporting deferred revenue. These include:
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Deferred revenue is easier for some businesses to manage and track than for others. For example, if you've leased a car or entered into a rental or insurance agreement, then the revenue is typically earned once the month following payment is complete. However, some businesses allow clients longer time frames to redeem a product or service, and the number of clients using a service can fluctuate. In the event of a service cancellation, there may be a requirement to refund the payment, making it essential for businesses to manage the utilization of deferred revenue with caution. Let's walk through how to address those challenges head-on.
Robust systems must be established to guarantee the accurate recognition of deferred revenues. It's helpful to use technology to manage your complete revenue lifecycle. Misreporting of deferred revenue can result in inaccuracies in financial statements, potentially misleading investors and regulatory authorities. This can harm your organization's reputation — and, in turn, your customer base. Some common challenges businesses face include:
Here are a few tips for addressing some of these challenges:
Managing deferred revenue can be tricky, but there are tools and resources to help make it much easier. Learn more about revenue recognition standards
and revenue recognition principles;
you'll be well on your way to counting your chickens before they're hatched — and properly accounting for them.
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