Have you ever thought about how businesses deal with money they’ve received before actually delivering a product or service? This scenario is common in industries with subscription models, long-term contracts, or advance deposits. The answer lies in a fundamental accounting concept known as deferred revenue.
Deferred revenue refers to income a company has collected upfront but hasn’t yet earned. Since the goods or services are still pending, this revenue must be recorded carefully to ensure financial statements remain accurate and compliant with accounting standards.
Here, we’ll explain what deferred revenue is, share some real-life examples, and show you how to properly record and manage it in your financial records.
Deferred revenue is the money a company receives in advance for products or services it hasn’t yet delivered. Also known as unearned revenue, it’s recorded as a liability on the company’s balance sheet because the business still owes the customer a product, service, or value in return.
Under the accrual accounting method, revenue is recognized only when it is earned, not when payment is received. This means that even though the business has collected the money, it cannot treat it as income until the service or product is provided.
Deferred revenue is commonly found in subscription-based businesses (e.g., SaaS platforms) or industries that require advance payments (e.g., gym memberships). To better understand unearned revenue, let’s look at some real-world examples.
Here are some common examples that show how it works:
Example: A customer pays SAR 450 for a one-year subscription. The company earns SAR 37.50 each month as they deliver the service.
Example: A customer buys a SAR 187.50 gift card. The company records it as unearned revenue until the card is redeemed for purchases.
Example: A customer pays SAR 3,750 for software updates over the course of a year. The company recognizes SAR 312.50 each month as the updates are delivered.
These examples illustrate that unearned revenue isn’t simply about receiving payment upfront but earning that money by delivering the promised product, service, or value over time. Now, let’s discuss why it’s important for companies to track it accurately in their financial statements.
Companies record deferred revenue to comply with accrual accounting standards. It’s treated as a liability because the business still owes the customer goods, services, or a refund for the payment it has received.
Since customer payments can be unpredictable, it’s more accurate for companies to recognize revenue when it’s actually earned, not when payment is made. This approach ensures that financial records reflect the timing of when products or services are delivered, rather than when the money is received.
Here are the top reasons for recording it:
Now, let’s explore how deferred revenue differs from deferred expenses, another important concept that may impact your finances.
Accounting concepts are quite complex. When you understand the differences between Deferred Revenue and Expenses, you’ll have a clearer picture of how to manage both in your business. Here’s how they differ:
To better understand how unearned revenue impacts your finances, let’s find out why it is considered a liability and how it affects your accounting records.
Under U.S. GAAP (and similar standards globally), deferred revenue is recorded on the balance sheet as a liability, reflecting the company’s ongoing responsibility to the customer. The revenue doesn't enter the income statement until the service is delivered or the product is provided.
Deferred revenue is typically listed as a current liability if it’s expected to be fulfilled within 12 months. Payments extending beyond that are categorized as non-current liabilities. This ensures your balance sheet accurately reflects the company’s financial commitments.
Here’s why deferred revenue is a liability:
Once the business delivers the product or service, the unearned revenue is recognized as actual revenue, and the corresponding tax is applied in the period the product or service is provided.
Deferred revenue becomes actual revenue when the business fulfills its part of the deal—i.e., when the product is delivered or the service is performed.
This follows the revenue recognition principle under accrual accounting, which states that revenue should be recognized when it is earned, not when cash is received. For example, if your business sells a 12-month subscription and receives full payment at the start, only a portion of the payment is recognized as revenue each month.
Now, let’s look at a detailed example of how a company records and then recognizes deferred revenue.
Let’s say you're running a software company, and a customer pays you SAR 24,000 for an annual subscription upfront. Since the service hasn’t been delivered yet, this payment needs to be recorded as deferred revenue.
When you receive the payment, the journal entry would look like this:
Here, Cash is debited because the company has received the payment, and Deferred Revenue is credited since the revenue hasn't been earned yet.
Each month, you recognize SAR 2,000 as earned revenue (SAR 24,000 ÷ 12 months). At the end of the first month, you’ll adjust the entry like this:
This process continues each month, where you move SAR 2,000 from Deferred Revenue to Revenue. By the end of the 12 months, the Deferred Revenue balance will be zero, and the company will have delivered the full service.
Understanding how this revenue is recorded helps us see its impact on financial statements. Let’s explore how it affects your balance sheet and income statement.
Deferred revenue affects your financial statements of your business in multiple aspects, including:
Properly managing deferred revenue helps maintain financial accuracy and supports long-term business growth. Let’s now explore the best ways to track and manage it effectively.
Managing deferred revenue can be challenging, especially for businesses with recurring revenue models or long-term contracts. Here’s how you can manage and track it:
By staying organized and using the right tools, you can manage unearned revenue and stay compliant. However, even the most diligent businesses can fall into common traps when it comes to this type of revenue. Let’s explore these pitfalls and how to avoid them to keep your finances on track.
Here are some common mistakes and tips on how to avoid them:
What to do: Recognize revenue only when the service or product is delivered, either monthly or based on milestones.
What to do: Regularly review and adjust deferred revenue to reflect customer changes or contract modifications.
What to do: Make sure deferred revenue is properly categorized on your balance sheet to maintain clarity and comply with IFRS standards.
Deferred revenue may seem like just another accounting term, but it plays an important role in maintaining the integrity of financial statements and business operations. By recognizing revenue only when earned, businesses provide a clearer view of performance for stakeholders.
Most businesses rely on accounting software to handle unearned revenue automatically. With HAL Accounting, you can easily track when payments are made, when services are delivered, and ensure your books stay in balance. HAL ERP simplifies tracking deferred revenue with:
Request a Demo with HAL ERP to get started!
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