What it means
The principle behind deferred income is that revenue is earned by delivering, not by invoicing or collecting. A customer who pays for a year's service in advance has given the business cash, but the business has not yet done anything to earn it.
Recording the receipt as revenue would report a year's income in a day, and would leave the following months, during which the service is actually provided and its costs incurred, with no revenue at all. Recording it as deferred income, and releasing one twelfth each month, puts the revenue in the months that earn it and matches it with the costs of providing it.
The liability is real, though it is unlike most liabilities. It is settled by performance rather than by cash: the business discharges it by providing the service, not by paying money back.
A customer who has paid for a year of software and used three months of it is owed nine months of software, and if the business closed, the customer would have a claim for the value of the undelivered service. Revenue recognition standards define the obligation precisely as a performance obligation and require the business to identify what it has promised, allocate the price to each promise, and recognise revenue as each promise is fulfilled, which for a continuous service means evenly over time and for goods means on delivery.
Government grants are the other main source of deferred income. When a business receives a grant towards the cost of an asset, such as a machine or a building, the grant is not income of the year of receipt; it relates to the asset's whole life.
It is held as deferred income and released to profit over the same period as the asset is depreciated, so that the net effect on profit each year is the depreciation less the grant release. Grants towards revenue costs, such as wage subsidies, are released as the related costs are incurred.
Where a grant is conditional and the conditions may not be met, it remains deferred until they are. Deferred income changes the way a business's balance sheet and cash flow should be read.
It sits in current liabilities, so a business that collects in advance can show a current ratio below one and a negative working capital position while being highly liquid, because the "liabilities" will be settled by delivering a service already paid for. Such businesses have a structurally favourable cash cycle: they collect before they spend, and growth generates cash rather than absorbing it.
The balance itself is information: an increasing deferred income balance means more has been sold than recognised, and revenue will follow; a shrinking balance means sales are slowing before the income statement shows it. Analysts of subscription businesses track billings (revenue plus the change in deferred income) for this reason.
The risks lie in recognition and in obligation. Recognising deferred income as revenue too early overstates results, and it is one of the most common forms of accounting misstatement, whether through error, aggressive interpretation or fraud.
On the other side, the cash received in advance is often spent on running the business, and the obligation to deliver remains; a business that has collected a year's subscriptions and spent them has, in effect, borrowed from its customers, and if it cannot deliver it faces refunds it may not be able to make. In acquisitions, buyers treat deferred income as debt-like to the extent of the cost of delivering the outstanding service, and in insolvency, customers who have paid in advance are usually unsecured creditors.
In practice
Real-world examples.
Example
An airline holds $800,000,000 of deferred income for tickets sold for future flights, which it recognises as revenue when each flight departs.
Example
A university receives tuition fees of $60,000,000 in September for an academic year running to June, and recognises the revenue evenly over the ten months of teaching.
Example
A retailer sells $2,000,000 of gift cards in December, records them as deferred income, and recognises revenue as the cards are redeemed, with a provision for the proportion that experience shows will never be used.
Think of it
“Deferred income is money received for work you haven't done yet-a liability until you deliver.
Formula
Calculation
Deferred income at period end = Deferred income at start + Cash received in advance during the period minus Revenue recognised from advance receipts during the period
Revenue recognised per period (time-based service) = Contract value / Number of periods in the contract
Grant release per period = Grant amount / Useful life of the asset (matching the depreciation pattern)
Billings = Revenue recognised + Change in deferred income
Worked example: memberships. A gym sells 2,000 annual memberships at $600 each on 1 January, all paid in advance.
- Cash received = 2,000 x $600 = $1,200,000; recorded as deferred income
- Revenue recognised each month = $1,200,000 / 12 = $100,000
- Deferred income at 30 June = $1,200,000 minus 6 x $100,000 = $600,000, representing six months of membership still to be provided
- The gym's balance sheet at 30 June shows a current liability of $600,000 that will be settled by keeping the doors open, not by paying cash
Worked example: government grant. A manufacturer receives a $500,000 grant towards a $2,000,000 machine with a ten-year life.
- At receipt: debit cash $500,000; credit deferred income $500,000
- Each year: depreciation $200,000; grant release $50,000 (debit deferred income, credit other income); net charge to profit $150,000
- Deferred income after year 3: $500,000 minus 3 x $50,000 = $350,000
- If the grant condition (retaining the machine in the region for five years) were breached in year 2, the unreleased balance would become repayable and would be reclassified as a liability to the government
Worked example: subscription business. A software company recognises revenue of $10,000,000 in a year; deferred income was $3,000,000 at the start and $4,200,000 at the end.
- Billings = $10,000,000 + ($4,200,000 minus $3,000,000) = $11,200,000
- Billings grew faster than recognised revenue, so the company has sold more than it has yet recognised, and next year's revenue starts with $4,200,000 already contractedCase study
Seen in the real world.
A vocational training company sold twelve-month courses, paid in full at enrolment, and had grown quickly by advertising. Its management accounts recognised each course fee as revenue on the day of enrolment, and on that basis the company reported revenue of $5,200,000 and a profit of $900,000, figures it used to support an application for a bank facility to fund a new training centre.
The bank required audited accounts, and the audit found the problem. At the year end, fees had been collected for courses that were on average only 40% delivered; the undelivered portion, $1,400,000, was deferred income, not revenue.
Restating on the correct basis reduced the year's revenue to $3,800,000 and turned the $900,000 profit into a loss of $500,000, because the costs of delivering the courses, mainly instructors' salaries and premises, had been incurred in the year while $1,400,000 of the revenue belonged to the next. The bank declined the facility on the restated figures.
The directors' first reaction was that the business was obviously profitable because it had $1,100,000 in the bank. The auditors' response was that the cash was the students' money for training the company had not yet given them, and that if enrolments stopped, the company would have to deliver $1,400,000 of courses with no further receipts. The board took two steps.
It moved the management accounts on to a deferral basis, so that monthly revenue reflected courses delivered, and it began to track the deferred income balance as a measure of the order book. On that basis the business turned out to be sound: it collected in advance, so growth generated cash, and once the timing of revenue was corrected its margins were adequate. The bank facility was granted a year later, on accounts that showed a modest profit and a $1,900,000 deferred income balance that the bank, correctly, read as future revenue already sold.
Watch out
Common mistakes.
- Recognising cash received in advance as revenue at the point of receipt, which overstates revenue and profit during growth and is one of the most common accounting misstatements.
- Reading a large deferred income balance as a sign of financial weakness because it sits in current liabilities, when it usually means the business has collected before delivering and is liquid.
- Spending advance receipts without regard to the obligation they carry, so that a slowdown in new sales leaves the business unable to fund delivery of what it has already sold.
Questions
People also ask.
What is the difference between deferred income and accrued income?
They are opposites. Deferred income is cash received before revenue is earned, a liability. Accrued income is revenue earned before cash is received or invoiced, an asset.
Is deferred income a debt?
Not in the ordinary sense, since it is settled by delivering a service rather than by paying cash. But it represents an obligation with a cost of fulfilment, and buyers of businesses often treat part of it as debt-like in pricing an acquisition.
Why do subscription businesses have negative working capital?
Because they collect in advance, so deferred income in current liabilities exceeds receivables and inventory in current assets. The position is favourable: the business is funded by its customers rather than funding them.
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