What it means
Accrual accounting records revenue when it is earned and expenses when they are incurred, not when cash moves, and cash often moves at a different time. When it moves later, an accrual records the revenue or expense before the cash, as with sales invoiced but not yet paid or wages earned but not yet paid.
When it moves earlier, a deferral records the cash first and holds the revenue or expense back until the period it belongs to. The customer who pays an annual subscription in January has paid for twelve months of service, and the company has earned none of it on the day the cash arrives; the company that pays a year's insurance premium in October has bought protection for twelve months and has used three of them by December.
Deferrals put the revenue and the expense into the right months. Deferred revenue, also called unearned revenue or deferred income, is the liability side: the cash has been received, but the company still owes the customer performance, such as the remaining months of a subscription, the delivery of goods or the completion of a course.
Until it performs, the company recognises a liability, and as it performs it reduces the liability and recognises revenue. Unusually among liabilities it is settled by delivering a service rather than by paying cash, and a company that fails is not usually required to refund it in full, but it is a real obligation with a real cost of fulfilment, and revenue recognition standards require it to be recognised.
Prepaid expenses, or deferred expenses, are the asset side: the cash has been paid but the benefit has not yet been received, as with rent for a period not yet begun, insurance cover for months not yet elapsed or advertising space booked for a future campaign. The payment is recorded as an asset, and as each period passes the portion relating to that period is transferred to expense.
The asset is not something the company can sell, but it represents a right to future service that has already been paid for. Businesses that collect in advance, such as software subscription companies, gyms, publishers and airlines, carry large deferred revenue balances that inflate current liabilities and can make the current ratio look weak even though the liability will be settled by delivering a service already priced.
For such businesses the deferred revenue balance is a leading indicator, because growth in the balance means future revenue already sold, and analysts track bookings, billings and deferred revenue alongside recognised revenue. In acquisitions, the buyer will treat deferred revenue as a debt-like item to the extent that it must fund the cost of delivering a service the seller has already been paid for.
Deferrals are also where revenue recognition goes wrong. A company that records cash received as revenue immediately overstates revenue and profit in the period of receipt and understates them later, which flatters growth while the business is expanding and reverses when it slows.
The discipline of deferring cash until it is earned, and the audit attention paid to it, exist because the temptation to recognise early is strong and the effect on reported results is large.
In practice
Real-world examples
Example 1
A magazine publisher receives $900,000 of annual subscriptions in its December promotion and recognises $75,000 of revenue in each month of the following year.
Example 2
A retailer pays $180,000 of rent quarterly in advance on 1 March and, at its 31 March year end, carries $120,000 as a prepayment for April and May.
Example 3
A training company that recognised course fees as revenue when paid restates its accounts to defer $1,400,000 of fees for courses not yet delivered.
Think of it
A deferral postpones recognition-you got or paid cash, but the accounting waits until later.
Formula
Calculation
Deferred revenue at period end = Cash received in advance minus Revenue earned to date
Prepaid expense at period end = Cash paid in advance minus Expense consumed to date
Revenue recognised in period = Deferred revenue at start + Cash received in period minus Deferred revenue at end
Portion earned or consumed = Total amount x Periods elapsed / Total periods covered
Worked example: prepaid expense. A company pays a $24,000 annual insurance premium on 1 October for cover to 30 September. Its financial year ends 31 December.
- At payment: debit prepaid insurance $24,000; credit cash $24,000
- By 31 December, three of twelve months have elapsed: expense = $24,000 x 3 / 12 = $6,000
- Adjustment: debit insurance expense $6,000; credit prepaid insurance $6,000
- Balance sheet at 31 December: prepaid insurance $18,000 (nine months of cover still to come)
Worked example: deferred revenue. A subscription business receives $120,000 on 1 November for a twelve-month service to 31 October.
- At receipt: debit cash $120,000; credit deferred revenue $120,000
- By 31 December, two months of service have been delivered: revenue = $120,000 x 2 / 12 = $20,000
- Adjustment: debit deferred revenue $20,000; credit revenue $20,000
- Balance sheet at 31 December: deferred revenue $100,000 (ten months of service still owed)
Worked example: a portfolio of subscriptions. A software company sells annual licences evenly through the year, receiving $3,600,000 in total, all paid in advance. On average, each licence is half delivered at the year end, so deferred revenue at the year end is about $1,800,000 and revenue recognised in the year from these sales is about $1,800,000. If the following year's sales rise to $4,800,000, deferred revenue rises to about $2,400,000 and revenue recognised is $1,800,000 (released from the opening balance) + $2,400,000 (earned from the new sales) = $4,200,000. Revenue lags cash collected by half a year's growth.Case study
Seen in the real world
This is a fictional, illustrative scenario. The founder of a software-as-a-service business, preparing to sell the company, presented management accounts showing revenue of $6,500,000, up 40% on the prior year, and a profit of $1,200,000. The accounts had been prepared on the basis that annual subscriptions were revenue when invoiced and paid, which the founder regarded as conservative because the cash was in the bank. The buyer's due diligence team recalculated on a deferral basis and reached a different picture.
At the year end, subscriptions invoiced and paid but not yet delivered amounted to $2,200,000, up from $1,300,000 a year earlier. Correctly deferred, revenue for the year was $6,500,000 minus the $900,000 increase in deferred revenue = $5,600,000, and against a restated $4,300,000 for the prior year, growth was about 30% rather than 40%. Profit fell to $300,000, because the costs of serving the subscribers had been recognised in the year while a portion of the revenue belonged to the next. The buyer also treated the $2,200,000 of deferred revenue as a debt-like item in the price adjustment, on the grounds that it would have to deliver a year of service for which the founder had already collected the cash: at a cost to serve of about 30% of revenue, that was $660,000 of future cost with no matching future receipt, and the price was reduced accordingly.
The founder's initial reaction was that the buyer was manipulating the numbers to lower the price. The buyer's finance director explained that the opposite was true: the deferral basis was the one required by accounting standards, the founder's management accounts had overstated both revenue and profit, and the business was still a good one, growing at about 30% with $2,200,000 of revenue already contracted for the coming year. The deal completed at a lower price than the founder had expected but a fair one for the business as it actually was. The founder's advisers noted that the management accounts should have been on a deferral basis from the start, and that presenting cash-basis figures to a sophisticated buyer had cost credibility as well as price.
Watch out
Common mistakes
- Recognising cash received in advance as revenue immediately, which overstates revenue and profit in the period of receipt and understates them when the service is delivered.
- Expensing an annual payment in full in the month it is paid, which distorts monthly results and makes the month of payment look worse and the others better than they were.
- Forgetting to release deferrals as periods pass, so that prepayments and deferred revenue accumulate on the balance sheet and the income statement misses the expense or revenue they represent.
Questions
People also ask
What is the difference between a deferral and an accrual?
Both align the accounts with activity rather than cash. A deferral records cash that has moved before the revenue or expense is recognised, and postpones the recognition. An accrual records revenue or expense that has been earned or incurred before the cash moves, and brings the recognition forward.
Is deferred revenue a real liability?
Yes. It is an obligation to deliver goods or services that have been paid for. It is settled by performance rather than by cash, so it does not have the same effect on liquidity as a loan, but it carries a real cost of fulfilment and must be recognised.
Why does deferred revenue matter to investors?
Because it is revenue already sold but not yet recognised. Growth in the balance signals future revenue; a fall can signal slowing sales before recognised revenue shows it. Subscription businesses are often analysed on billings, which add the change in deferred revenue to recognised revenue.
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