What Is Deferred Revenue? (With Definition And Examples)

By Indeed Editorial Team

Published 20 October 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Several businesses receive payment for goods and services that they are yet to deliver to a customer or another business. This is predominant in automobiles, publishing, manufacturing and e-commerce industries. If you work in finance, learning about deferred revenue, also known as unearned revenue or income, can help you understand how companies record advanced payments on their balance sheet. In this article, we discuss what deferred revenue is, share steps to record it on a balance sheet, outline its advantages and limitations and list business types that benefit from advance payments.

What Is Deferred Revenue?

Deferred revenue is a payment that a company receives for goods, products and services that it has not yet delivered. A company records this payment as a liability on its balance sheet for the period between payment date and delivery of service. It records it as a current liability if it delivers the product or service within 12 months. If the time period exceeds 12 months, it requires recording it as a non-current liability. Unearned revenue is a liability for a company because:

  • It has an obligation to provide products and services as per the payment received.

  • It may not deliver a product or service as originally planned because of unforeseen circumstances.

  • It may require issuing a refund if a customer cancels the order.

Unearned revenue allows companies to reflect their revenues in the balance sheet when they deliver the service, either one-time or recurring, to a customer. This makes accounting easier and more accurate and helps a company keep a track of its revenue against its expenses. It also helps reduce taxes by reducing the net income. The value of unearned revenue can never be negative. If the value is negative, it implies that there is a mistake in the calculation, indicating a company has paid the customer instead. In that case, it becomes a negative liability.

Related: What Are Current Liabilities? (And How To Record Them)

How Does Unearned Revenue Work?

Consider the example of a literary magazine publisher that provides three subscription models for its customers. It offers an additional discount if customers choose semi-annual and annual plans. The company also offers a large discount on two-yearly subscriptions. Some customers make a payment for long-term subscriptions, which include semi-annual and annual plans. A few customers choose the two-yearly subscription to avail of an additional discount.

The payments that the company receives are unearned revenue. It has an obligation to send monthly magazines in print format to a customer's physical address. At the end of each month, the company can deduct the amount from its liabilities and record it as revenue earned. If a customer wishes to unsubscribe, the company requires returning the remaining amount back.

How To Record Unearned Revenue

Follow these steps if you want to record unearned revenue on a company's balance sheet:

1. Determine the time-period

The first step in recording an unearned income is to determine the time period for which the customer has made the payment in return for the products and services that they are yet to receive. If the company can deliver the required service within 12 months, record it as a current liability on the balance sheet. In case the period exceeds 12 months, record it as a non-current liability, also known as a long-term liability. Consider the example:

A cloud vendor offers discounts on cloud services if customers choose the annual subscription. The cost of the service is ₹5,000 per month after the discount. The customer requires paying ₹60,000 since this is an annual billing. In this example, the service period is 12 months and the customer pays the fee up-front. The company receives ₹60,000 and requires providing services to the customer until the end of one year.

Related: How To Conduct Analysis Of Financial Statements (With Steps)

2. Record the amount paid

After determining the type of liability, record the payment made by the customer in the balance sheet. You can also record it as a journal entry in the following manner:

This is the entry made in the journal when the company receives the payment.

Debited revenue Credited revenue Cash ₹60,000
Current liability ₹60,000

Related: Balance Sheet Vs Income Statement (Key Differences)

3. Recognise the revenue

After the company has delivered the service, you can recognise the amount as revenue generated. Deduct the amount from the company's liabilities and add it to the revenue earned. Continuing the previous example:

This is the entry made in the journal after the first month:

Debited revenue Credited revenue Cash ₹55,000

Current liability ₹5,000

This is the entry made in the journal after the second month:

Debited revenue Credited revenue Cash ₹50,000

Current liability ₹10,000

Related: Basics Of Accounting - Terminology, Principles And Concepts

What Is The Difference Between Accounts Receivable And Deferred Or Unearned Revenue?

Deferred or unearned revenue is a liability on a company's balance sheet rather than an asset because it is yet to deliver the products and services to customers. It is an example of an unearned income. Accounts receivable are an asset on the balance sheet because these are products or services delivered to a customer for which they are yet to pay. These are services sold on credit.

Related: How To Write An Accounts Receivable Resume (With Template)

Advantages Of Unearned Income

The advantages of unearned income are:

Protects against debt

With unearned revenue, there is no uncertainty regarding customers' payment for products and services. This avoids scenarios of delayed and non-payments. Since a company has already received the money, it can focus on delivering timely and quality service.

Related: What Is Capital Structure? (With Types And Ways To Use It)

Prevents overvaluation of a business

Unearned revenue is a liability and does not count as revenue until a customer has received the product or service. This prevents companies from recording their actual revenue and unearned revenue together. Doing so avoids the overvaluation of a business.

Related: Finance Interview Questions For Freshers (With Answers)

Improves cash flow

In the case of unearned revenue, a company has already received the payments, which helps improve its cash flow. Improved cash flow results in growth and expansion opportunities. This also enables businesses to cover other obligations, re-invest in the business, pay expenses and have cash for future financial challenges.

Related: Format Of A Cash Flow Statement (With Methods And Examples)

Makes it easier to deliver products and services

There may be situations when a small business may not have enough capital to start the production of goods and services. For example, a company may require an expensive raw material to start production. Unearned revenue enables a company to buy the required raw material with the advance payment they receive from the customer and start the production work.

Related: What Are Services? (A Comprehensive Guide With Examples)

Limitations Of Unearned Revenue

The limitations of unearned revenue for a company are:

  • It has an obligation to the customer. Once a company receives payment for a product or service, it requires ensuring timely and quality delivery. A compromise in the quality of service can result in customers cancelling their orders and losing trust in the company.

  • It may not be able to fulfil its orders. A company may face difficulty delivering products and services when the demand is very high, even though they have received the payments. The inability to deliver products on time can cause customers to cancel their orders.

  • It can affect the financial status of a company. Many companies may combine the actual revenue with unearned revenue, which is a liability. This can project the wrong profitability numbers along with a false idea of growth.

Related: What Is Revenue? Definition, Types, Examples And More

Businesses With Significant Unearned Revenue

Here are examples of businesses with significant unearned revenue:

  • Automobile industry: It is common for automobile manufacturing companies to receive payments in the form of pre-bookings for vehicles that would take months to deliver.

  • Publishing industry: Magazine publishers receive payments for annual subscriptions that they deliver to the customer throughout the year.

  • Phone companies: Phone companies bill their customers with pre-paid plans, which is an example of advanced payment.

  • Live events: Ticket-selling platforms require customers to book their tickets in advance to reserve seats for an event.

  • E-commerce platforms: Online retailers have an option of credit and debit card payments for pre-orders, where customers pay for their orders before the packaging and shipment.

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