What Is Deferred Revenue, and Is It Worth the Risk?

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.

What you'll learn:

• What is deferred revenue?
• Examples of deferred revenue
• Accounting for deferred revenue
• Impact of deferred revenue on financial statements
• 4 benefits of proper deferred revenue management
• How to manage and track 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.

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:

• Subscription and streaming services: Many SaaS software companies, retailers, telecommunications companies, and streaming services in the entertainment and media industries offer subscriptions for content, products, or services in advance of delivery. For example, if you sign up for a streaming service and pay for an annual subscription, the streaming service can't count the fee as revenue until you've spent a year watching all your favorite TV shows.
• Travel and hospitality: Many hotels, airlines, and car rental companies charge a partial (or sometimes full) fee upon booking and receive the balance at a later date, once the travel takes place.
• Membership- or tuition-based businesses: Gyms, country clubs, or even educational institutions may require payment up front as a means of securing your space or membership. This ensures that the organization consistently earns money whether or not you make it to kickboxing class.
• Rental or leasing agreements: Rental payments for real estate or auto leases are typically collected for one or several months in advance and are also considered deferred revenue.
• Insurance: Similarly, most forms of insurance are prepaid (and with any luck, may never need to be used). While most insurance is billed monthly, some forms are paid on an annual basis.
• Independent consultants or professionals: Any professional who works on retainer, such as a lawyer, private physician, business consultant, etc., is typically paid in advance with an agreement to deliver up to a set amount of work within a given period of time. This may also include tutors, music teachers, housecleaners, and so forth if they package and bill their work in advance.
• Gift cards: Even products as simple as these are classified as deferred revenue and considered a liability. Payment received from the sale of the gift certificate doesn't qualify for revenue recognition until the certificate has been redeemed.

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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:

1. Recognize deferred revenue as a liability on the business's balance sheet.
2. Move the revenue to shift the funds to the earned revenue section of the business's income statement after the product or service is delivered.
3. Reflect and manage changes on cash flow statements. Increases in deferred revenue are considered cash inflows, while decreases result in cash outflows.

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.

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Beyond due diligence and meeting compliance standards, there are several important benefits of effectively managing and reporting deferred revenue. These include:

1. Minimized tax obligations: By aligning revenue recognition with the delivery of products or services, a company can effectively minimize its tax obligations. For example, if a service is scheduled for delivery in the following financial year, and the associated costs are also expected to occur in that same period, it's best to recognize the revenue in the income statement of the subsequent financial year for tax considerations.
2. Enhanced financial precision: Many businesses receive advance payments, yet customers retain the right to cancel the service or receive a refund. At scale, this can be significant. An airline might anticipate, for example, full flights to a tropical island over the summer — until a weather advisory causes passengers to change or cancel their trips. In these scenarios, recognizing deferred revenue accurately reflects the business's income. In this way, the money isn't spent or invested elsewhere before it is earned.
3. Improved revenue forecasting: Deferred revenue is instrumental in projecting future revenue potential and assessing the company's capacity to fulfill its commitments. Payments made in advance do not always reflect what actual usage may look like. Consider that subscription or streaming services may need to scale to meet demand and must be able to cover the cost of parts and/or labor to do so. For example, at WCS, the instructor and baking supplies must be accounted for whether or not all the students actually attend the class.
4. Enhanced risk management: By acknowledging that received payments are not yet earned, businesses can allocate funds more prudently, thereby positioning themselves to better handle unforeseen circumstances. Unfortunately, factors such as weather, political instability, data breaches, public health crises, or damage to brand reputation can have a swift and detrimental impact on revenue.

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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:

• Service cancellations: It's crucial to carefully draft contractual clauses with customers to ensure that organizations are adequately protected in the event of service cancellations.
• Delays in service delivery: Any delays in service delivery within the organization should be promptly communicated to the accounting department. If that isn't handled properly, your financial statements will not be accurate.
• Unforeseen events: Every business needs to have contingency plans in place. Even the best product or service can suffer from a social media storm or other misfortune. If deferred revenue is too quickly reallocated, there is a risk that you won't be able to deliver your product or service when you really need to.

Here are a few tips for addressing some of these challenges:

• Keep your accounting team informed. The lines of communication need to stay open even after a payment is processed so that accounting knows a corresponding service or product has yet to be delivered — and when. Close collaboration between your sales, delivery, accounting and/or revenue operations teams is necessary to ensure clarity regarding the delivery schedule. Promptly inform your accounting team about any known delays or cancellations related to the delivery of the product or service.
• Implement tools and establish protocols. Keep the accounting team updated on deferred revenue and its delivery status, allowing for accurate revenue recognition. Using traditional accounting software can help recognize deferred revenue.
• Provide tool training. This is also critical so that your accounting team understands how to manage unearned revenue and other things, such as usage-based pricing, within any systems you adopt.
• Perform regular audits. Ensure that the recognition of deferred revenue corresponds with the actual services rendered and products delivered (in the most applicable tax year).

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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.