What is Deferred Revenue and How Does it Work

When running your own SaaS, operating in ecommerce, or starting your own company in any other industry, you may encounter different revenues. Some will be accrued immediately, while others will come over time. 

The second ones are called deferred revenue, and today we'll talk more about them. So, if you are unfamiliar with this term and want to know more, this article is for you.

What is Deferred Revenue?

Deferred revenue, also called unearned revenue or deferred income, is a common accounting practice that helps companies properly recognize revenue over time. It works according to the matching principle, which states that revenue should be recognized when earned, not before.

In simple words, this approach is not the same as actual revenue. 

Deferred revenue liability acts like a promise of revenue until the goods or services are delivered - then, it becomes revenue. 

It's a critical concept in accounting, especially for businesses with subscription-based or long-term service contracts.

How Deferred Revenue is Generated

Deferred revenues are generated when a business receives advance payments from customers for goods or services that have not yet been delivered or earned.

Here's the process in more detail:

• Advance payment - a business receives cash payment, checks, or credit cards from a customer before it has provided the products or services.
• Obligation to deliver - in exchange for these payments, the business must provide the customer with products or services later. This obligation is typically outlined in a contract or agreement between the business and the customer.
• Revenue record - instead of recognizing the entire payment as revenue immediately, the business records the payment as deferred revenue on its balance sheet. This means the payment is recorded as a liability because the company owes the customer goods or services in the future.
• Recognition over time - as the business fulfills its obligation by delivering the goods to the customer, it gradually recognizes the deferred revenue as actual revenue on its income statement. Revenue is recognized in proportion to the work completed or the goods delivered.

Does it remind you of the way subscriptions work? And aptly so!

Benefits and Challenges of Deferred Revenue

Deferred revenues have an important role and provide many benefits. However, they also present some challenges.

So, let's meet the pros and cons of this revenue.

⭐ Benefits

#1 Accurate revenue recognition

It ensures that revenue is recorded in a manner that accurately reflects the performance of the business and provides a clear picture of the company's balance sheet. It also allows recognizing revenue in accordance with the revenue recognition principle, which is a fundamental concept in accrual accounting.

#2 Steady cash flow

Recording annual subscription payments as deferred revenue can help ensure a steady cash flow over time. Instead of receiving a large sum of cash upfront and potentially facing cash flow challenges later, the company receives the revenue evenly over the subscription period.

#3 Transparency

Deferred revenue is reported as a liability on the balance sheet, which provides transparency about the company's obligations to deliver goods or services in the future.

🚫 Challenges

#1 Can make the wrong impression

Deferred revenue can result in lower sales revenue on the income statement initially. This can give the impression of poorer company performance.

#2 Can be complex

Managing deferred revenue can be complex, especially for businesses with multiple revenue streams or complex contract terms. Thus, companies must accurately track and record deferred revenue for each transaction.

#3 It's less flexible

Deferred revenue can create challenges for cash flow. Since companies haven't received the entire payment yet, they can't afford to make large investments, which they would do if they already had all the revenue. But this problem can be avoided by properly planning expenses.