Most businesses will agree that properly distinguishing between deferred revenue and unearned revenue is critical for accurate financial reporting.
In this post, you'll learn the key differences between deferred and unearned revenue, how to account for each one properly, and see examples of journal entries for deferred revenue transactions.
We'll explore the subtle distinctions between the terminology, their treatment under GAAP, presentation on financial statements, and implications for revenue recognition and cash flows. You'll also find detailed examples of deferred revenue from subscription services, insurance premiums, gift cards, and software licenses.
Introduction to Deferred and Unearned Revenue
Deferred revenue, also known as unearned revenue, refers to payments received in advance for products or services that are still owed to customers. It is recorded as a liability on a company's balance sheet until the products/services are delivered.
Exploring the Concept of Deferred Revenue
Deferred revenue arises when a company receives payment but has not yet fulfilled its obligation to the customer. For example:
- A customer prepays for a yearly software subscription. The software company initially records this as deferred revenue since the service has not yet been provided.
- An online retailer receives an order payment but has not yet shipped the goods to the customer.
In both cases, the company has an obligation to deliver products/services in the future. GAAP accounting rules require deferred revenue to be classified as a liability until earned.
Understanding Unearned Revenue as a Liability
Unearned revenue is another term for deferred revenue. It refers to advance payments for products or services that are still owed to a customer. Key aspects:
- Recorded as a current liability on the balance sheet
- Remains on the books until revenue is "earned"
- Reduces to $0 as goods/services are delivered over time
Unearned revenue is a type of accounting conservatism. Companies cannot count payments as revenue until they satisfy performance obligations under the revenue recognition principle.
Distinguishing Between Deferred and Unearned Revenue
While often used interchangeably, subtle differences exist:
- Deferred revenue emphasizes timing and revenue recognition
- Unearned revenue focuses on outstanding performance obligations
Both refer to the same underlying concept - payments received in advance of delivery. Choosing one term over the other is mostly a matter of preference.
Analyzing Deferred Revenue on the Balance Sheet
On the balance sheet, deferred revenue is recorded as a liability. Key implications:
- Increases the current liabilities section
- Decreases net income in the current period
- Converts to revenue over time on the income statement
Tracking changes in deferred revenue each period provides insights into sales growth and fulfillment rates. As obligations are met, deferred balances decline and earned revenue increases.
Illustrating Concepts with Deferred Revenue Examples
Common examples that generate deferred/unearned revenue:
- Subscriptions: Payment upfront for future access, recognized over the subscription term
- Insurance premiums: Coverage prepaid annually, recognized monthly
- Gift cards: Payment received without product/service delivery
- Advance payments: Deposits for future orders, recognized on delivery
In each case, cash is received before revenue can be earned. This results in a liability that reduces as obligations are fulfilled.
Is unearned revenue the same as deferred?
Deferred revenue and unearned revenue refer to the same accounting concept and can be used interchangeably. They both represent revenue that has been collected but not yet earned by a company.
When a company receives payment in advance for products or services that will be delivered or performed in the future, they cannot recognize this revenue on their income statement yet. Instead, they record it as a liability on their balance sheet until the revenue is actually earned.
Here is an overview of deferred/unearned revenue:
- Represents products or services that still need to be provided to a customer after payment has been made
- Recorded as a liability on the balance sheet
- Revenue is not recognized until the performance obligation is fulfilled
- Common examples include:
- Annual software subscriptions
- Prepaid insurance policies
- Gift cards
- Once the product/service has been delivered, the liability is reduced and revenue is recognized on the income statement
In summary, deferred revenue and unearned revenue refer to the same concept - money received in advance for goods and services not yet provided. Companies use these accounts to adhere to the revenue recognition and matching principles in accrual accounting. Recording them as liabilities allows for accurate financial reporting.
What is accrued revenue vs deferred revenue vs unearned revenue?
Accrued revenue, deferred revenue, and unearned revenue are important concepts in accounting that relate to the timing of revenue recognition. Here is a brief overview of each:
Accrued Revenue
- Revenue that has been earned but for which no payment has yet been received.
- Recorded as an asset on the balance sheet.
- Common examples include services rendered but not yet billed, interest earned but not yet received.
Deferred Revenue
- Also known as unearned revenue.
- Refers to payments received in advance of providing goods or services.
- Recorded as a liability on the balance sheet.
- Revenue is recognized and moved from the liability account to the income statement when goods/services are delivered.
Unearned Revenue
- Another term for deferred revenue (used interchangeably).
- Represents obligations to provide goods or services that have not yet been fulfilled.
In summary, accrued revenue is earned but not yet received, while deferred/unearned revenue is received but not yet earned. Proper revenue recognition as per accounting principles is important for accurate financial reporting.
Is unbilled revenue the same as deferred revenue?
No, unbilled revenue and deferred revenue are distinctly different accounting concepts.
Deferred revenue refers to money received in advance for products or services that have not yet been delivered or performed. It is recorded as a liability on the balance sheet because the business owes goods or services to the customer.
For example, if a customer pays for a 1-year magazine subscription in January, the business would record the full amount as deferred revenue. As each month's issue is delivered, 1/12th of the revenue would be recognized on the income statement and removed from the deferred revenue liability.
Unbilled revenue is the opposite - it represents goods or services that have been provided but payment has not yet been received. Unbilled revenue is recorded as an asset on the balance sheet.
For instance, if services were performed in December but the invoice will not be sent until January, the December services would be tracked as unbilled revenue. Once the invoice is sent and the customer pays, the amount moves from unbilled revenue to accounts receivable.
In summary, deferred revenue is a liability for pre-payments, while unbilled revenue is an asset for services already completed. Businesses recognize deferred revenue over time, while unbilled revenue is recognized immediately after invoicing. Properly distinguishing between the two is important for accurate financial reporting.
Is deferred revenue an asset or liability?
Deferred revenue is considered a liability, not an asset, on the balance sheet. This is because it represents products or services that a company still owes to its customers.
When a company receives payment in advance of delivering goods or services, it records this prepayment as deferred revenue. This liability represents the obligation that the company has to provide the goods or services in the future.
Some key things to know about deferred revenue as a liability:
- Deferred revenue is classified as a current liability if the products/services will be delivered within 12 months. If longer than 12 months, it is considered a long-term liability.
- Under the accrual basis of accounting and the revenue recognition principle, revenues can only be recorded on the income statement when they are earned. Deferred revenue does not meet this criteria.
- On the balance sheet, deferred revenue represents products or services still owed to customers. It is not yet "earned revenue" that can be recognized on the income statement.
- The balance sheet liability will be reduced once delivery of the related products/services occurs. At that point, the revenue will be recognized on the income statement.
So in summary, deferred revenue is unequivocally considered a liability, not an asset, due to the outstanding obligation it represents to customers. It remains on the balance sheet until the terms of revenue recognition are met.
Comparing Deferred Revenue and Unearned Revenue
Deferred revenue and unearned revenue are closely connected concepts in accounting. While subtle differences exist, they are often used synonymously to refer to money received by a company before it has provided the related goods or services.
Assessing Common Usage in Accounting
In practice, many accountants use the terms "deferred revenue" and "unearned revenue" interchangeably. Both refer to revenue that has been collected but not yet "earned" because the company still owes products or services.
Some examples include:
- Prepaid annual software subscriptions
- Advance payments for maintenance contracts
- Upfront deposits for big projects
Since the company has received cash but has not yet delivered the related goods/services, it cannot recognize the revenue. So it is initially recorded as a liability on the balance sheet.
Identifying Subtle Differences in Terms
Technically, deferred revenue is a broader concept that covers both short-term and long-term liabilities for unearned revenue.
- Deferred revenue - Includes all products/services owed to customers (regardless of timeframe).
- Unearned revenue - Specifically refers to the current liability account balance for goods/services owed within 12 months.
For example, a 2-year magazine subscription would initially get $100 deferred revenue. After 12 months, $50 would get moved from deferred revenue to earned revenue, while the remaining $50 balance would be unearned revenue.
Understanding GAAP Treatment of Deferred Revenue
Under Generally Accepted Accounting Principles (GAAP), deferred revenue is typically the preferred term used on the balance sheet and income statement. It aligns with the revenue recognition principle and covers both short and long-term liabilities.
Some reasons it is commonly used under GAAP include:
- Emphasizes revenue has not yet been "earned"
- Highlights money owed for future performance obligations
- Provides a more conservative view of unrealized income
- Allows easier reporting across multiple fiscal year periods
So in financial reporting, businesses tend to favor deferred revenue as it encompasses the wider set of product/service obligations owed to customers over time.
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Accounting for Deferred Revenue and Unearned Revenue
We break down the main differences between deferred revenue vs unearned revenue from an accounting perspective.
Examining Time Horizon: Current vs Long-term Liability
Deferred revenue encompasses both short-term (current liabilities) and long-term liability balances, while unearned revenue typically only refers to short-term balances.
For example, if a company receives a 3-year prepayment for services, the portion expected to be earned within one year would be classified as unearned revenue (a current liability), while the remaining multi-year portion would be considered deferred revenue as a long-term liability.
Key differences:
- Deferred revenue liability can be split between current and long-term on the balance sheet. Unearned revenue is only shown as a current liability.
- Deferred revenue recognizes both short and long duration prepayments. Unearned revenue focuses strictly on short-term balances expected to be earned within a year.
So in summary - deferred revenue is a broader term that covers both current and future prepayments, while unearned revenue is specifically used for short-term liabilities.
Defining the Scope of Deferred Revenue
The term "deferred revenue" refers broadly to any and all prepayments received for products or services that are still owed to a customer. This encompasses:
- Unearned revenue liability accounts
- Long-term deferred revenue balances
- Other prepayments like prepaid rent, prepaid insurance, etc.
Essentially, deferred revenue refers to the general concept of prepayments, while "unearned revenue" specifies the actual liability account on the balance sheet for near-term service obligations.
A few key differences in scope:
- Deferred revenue is a broad concept covering all prepayments
- Unearned revenue is specifically the current liability account for soon-to-be delivered products/services
- Other prepayments like prepaid rent are types of deferred revenue but not unearned revenue
So in definition, deferred revenue refers to the overall category of obligations, while unearned revenue is the short-term liability account subset.
Presentation on Financial Statements: Deferred Revenue vs Unearned Revenue
On financial statements, deferred revenue impacts:
- Balance Sheet: Current + long-term liability sections
- Cash Flow Statement: Operating activities
- Income Statement: Revenue recognition over multiple periods
Whereas unearned revenue is specifically shown as a current liability on the balance sheet.
When prepayments are made for services not yet delivered, deferred revenue is credited on the balance sheet across short and long-term liability accounts as needed. As goods/services are provided over time, deferred revenue is debited and revenue is recognized on the income statement.
Unearned revenue, as a subset of deferred revenue, follows the same process but is limited to only the short-term liability account, given its shorter duration.
In summary - deferred revenue provides a more comprehensive view across financial statements, while unearned revenue focuses solely on the current liability component.
Financial Statement Implications of Deferred and Unearned Revenue
Recording Deferred Revenue in Balance Sheet Accounts
When a business receives payment in advance of providing goods or services, this prepayment is considered a liability, as the business now owes the customer delivery of the product or service. Under accrual accounting and the revenue recognition principle, revenue should only be recorded when it is earned by the transfer of goods or services.
To record these advance payments, deferred revenue accounts are used. Typically, cash is debited and a deferred revenue account is credited. This represents the prepayment as a liability on the balance sheet. As goods or services are subsequently delivered over time to the customer, the deferred revenue balance sheet account is reduced and revenue is recognized on the income statement.
For example, if a SaaS company receives a $1,200 prepayment for a 1-year software subscription, the initial journal entry would be:
Debit Cash $1,200
Credit Deferred Revenue $1,200
This deferred revenue liability represents services still owed to the customer over the contract term.
Recognizing Revenue on the Income Statement
As the SaaS company delivers services each month, deferred revenue is reduced and subscription revenue is recognized on the income statement. For example, each month $100 would be recognized as revenue and deferred revenue drawn down.
The journal entry would be:
Debit Deferred Revenue $100
Credit Subscription Revenue $100
This process continues until the end of the contract term when the deferred revenue balance reaches zero, indicating all services have been delivered.
Impact on Cash Flow from Operating Activities
On the statement of cash flows, advance customer payments that increase deferred revenue lead to positive cash inflows from operating activities. Subsequently, the fulfillment of obligations to customers leads to negative cash outflows.
The initial $1,200 prepayment received would be recorded as cash inflow under operating activities. The $100 monthly recognition of subscription revenue would be a reconciling item shown under operating cash flows as $100 of deferred revenue relieved.
Over the term, these advance inflows and outflows showcase the timing impact to cash from operations based on revenue recognition principles. Companies with significant deferred balances can have material differences between accrual net income and cash from customers.
Journal Entries for Deferred Revenue
Deferred revenue, also known as unearned revenue, refers to money received in advance for products or services that are owed to a customer. Understanding the accounting entries for deferred revenue transactions is important for properly recording revenue and liabilities.
Creating a Deferred Revenue Journal Entry
When a business receives cash in advance of delivering goods or services, it must record a deferred revenue journal entry. This entry increases the "Deferred Revenue" liability account to represent the obligation to provide the product or service in the future. It also increases cash.
Here is an example deferred revenue journal entry:
Debit Cash - $1,000
Credit Deferred Revenue - $1,000
This entry records receipt of $1,000 cash for a 1-year magazine subscription when the magazines have not yet been delivered. It increases the deferred revenue liability to represent the obligation to provide magazines over the next year.
Amortization of Deferred Revenue
As products or services are delivered each period, deferred revenue is systematically recognized on the income statement. This process of reducing a deferred revenue liability over time is called amortization.
Each period, a journal entry must be recorded to recognize the portion of deferred revenue earned as actual revenue. This deferred revenue amortization entry decreases the deferred revenue liability account and increases revenue.
For example, if 1/12th of the magazines are delivered each month, the monthly amortization entry would be:
Debit Deferred Revenue - $83.33
Credit Revenue - $83.33
This recognizes $83.33 of revenue on the income statement, while reducing the deferred revenue obligation.
Adjustments and Reversals
Sometimes deferred revenues may need to be adjusted or reversed, such as when a customer cancels a subscription early.
If a customer cancelled their magazine subscription after 3 months, the remaining 9 months of deferred revenue would need to be reversed, since the magazines will no longer be delivered.
This deferred revenue reversal entry would be:
Debit Deferred Revenue - $750
Credit Revenue - $750
Properly recording deferred revenue and related journal entries is important for accurate financial reporting. Following GAAP revenue recognition principles helps ensure revenues are matched with expenses in the proper periods.
Tax Treatment of Deferred Revenue
Deferred revenue, sometimes referred to as unearned revenue, has important implications for tax reporting. Here's what businesses need to know:
Deferred Revenue Tax Implications
When a business receives payment for products or services that will be delivered in the future, they must record this transaction as deferred revenue on their balance sheet. For tax purposes, the full amount of the payment is generally considered taxable income in the year received, even if some or all of the earnings will be deferred to later years on the company's financial statements.
This creates a timing difference between taxable income and book income. Companies must be aware of this difference and how it impacts their tax liabilities from year to year as deferred revenue is earned. Careful tax planning is important.
Comparing Cash Basis and Accrual Accounting for Taxes
How deferred revenue is treated can vary depending on a company's accounting method:
Cash basis - With this simpler method, deferred revenue is not recorded at all. Companies only report earnings on their tax return in the year cash is actually received. This avoids timing issues but fails to match revenue and expenses.
Accrual basis - The more complex accrual method requires companies to record deferred revenue on their balance sheet when payments are received for future products/services. As outlined above, the full amounts are still generally taxed when received despite being deferred to later years on financial statements.
In summary, deferred revenue can create timing differences between tax and financial accounting. Understanding these implications allows businesses to better plan and manage their tax obligations. Consultation with accounting and tax professionals is highly recommended.
Detailed Examples of Deferred Revenue and Unearned Revenue
We walk through several real-world examples of deferred/unearned revenue transactions.
Subscription Services Revenue Recognition
Publications receive cash upfront for future magazine or newspaper issues and recognize revenue over subscription term. For example, a magazine may sell a 1-year, 12-issue subscription for $120. The magazine cannot recognize the full $120 upfront since it owes the subscriber 12 issues over the next year. Using accrual accounting, the magazine would record $10 of revenue per issue.
- The magazine receives $120 cash upfront when the subscription starts
- This is recorded as a deferred revenue liability since issues are owed
- Each month $10 is recognized as revenue and the liability reduced
- After 12 months the entire $120 has been recognized as revenue
This matches revenue with delivery and better reflects ongoing financial performance.
Insurance Premiums as Prepaid Expense
Insurers receive premiums in advance to provide coverage for future periods, recognized over the policy term. For example, a 1-year $1,200 home insurance policy would be recorded with a $1,200 increase in a cash/liability account. Over the next 12 months, $100 per month moves from the prepaid liability account to insurance expense.
- Premium fully received upfront at policy start
- Recorded as deferred revenue since coverage is owed
- Over 12 months, $100 per month moves to insurance expense
- Better matches revenue with delivery of coverage
This approach is mandated under GAAP revenue recognition principles.
Gift Card Sales and Revenue Recognition
Retailers sell gift cards in advance of products or services to be delivered to gift card recipients. Revenue is recognized when the gift card is ultimately redeemed. For example:
- Customer purchases $50 gift card
- Retailer records $50 cash and $50 gift card liability
- When gift card is used, retailer recognizes $50 of revenue
- Liability reduced until gift card fully redeemed
Revenue recognition matches when end products/services are delivered.
Deferred Revenue from Software Licensing Agreements
Technology firms sell term-based software licenses, recognizing license revenue ratably over the access period. For example:
- Customer signs a 3-year $3,000 CRM software license
- Software firm cannot recognize all $3,000 upfront
- $1,000 deferred revenue liability recorded each year
- $83.33 recognized as monthly recurring revenue
- Continues until term expires
This complies with revenue recognition principles and conservatism in GAAP accounting.
Conclusion: Understanding the Importance of Revenue Recognition
Summarizing Deferred and Unearned Revenue
Deferred revenue, also known as unearned revenue, refers to money received by a company for products or services that have not yet been delivered or performed. It represents an obligation for the company to provide goods or services in the future. Key things to know:
- Deferred revenue is recorded as a liability on the balance sheet, representing products or services still owed to customers.
- It shifts to revenue on the income statement once the company fulfills its obligation and delivers the goods or services.
- Understanding deferred revenue is important for accurate financial reporting under accounting principles like revenue recognition and the matching principle.
Highlighting Key Accounting Principles
There are some key differences between deferred revenue and unearned revenue:
- Deferred revenue tends to refer to longer-term obligations, while unearned revenue typically refers to short-term obligations.
- Deferred revenue recognition may span multiple financial reporting periods before fulfillment, while unearned revenue tends to convert to earned revenue within a single period.
- On the balance sheet, deferred revenue is usually listed as a long-term liability, while unearned revenue is a current liability.
In both cases, the treatment follows core accounting principles around revenue recognition and conservatism required for accurate financial statements.
Implications for Revenue Recognition and Financial Analysis
Proper categorization of deferred vs unearned revenue ensures revenues are matched to expenses in the correct reporting period. It prevents premature revenue recognition and overstatement of income.
Analysts assess deferred revenue balances and changes to evaluate business growth and health. Increasing deferred revenue suggests upfront cash payments from customers, indicating strong future business performance when obligations are fulfilled. High or growing deferred revenue may also represent dependence on prepayments rather than recurring billings.
