What it means
Under accrual accounting, revenue is recognised when the business satisfies its obligation to the customer, not when the cash arrives. A customer who pays $1,200 in January for a year of service has given the business cash, but the business has not yet earned it; it has promised twelve months of service.
Recording the full $1,200 as January revenue would overstate January and leave the next eleven months with costs but no income. Instead, the business records $1,200 of deferred revenue and releases $100 to revenue each month as the service is delivered.
Deferred revenue is a liability because the business owes the customer either the service or a refund. It is usually a current liability, because most prepayments cover a year or less, but a three-year contract paid up front would have part classified as non-current.
Unlike most liabilities, it is settled by performance rather than by paying cash, and the cost of that performance is normally far less than the liability's face value. That makes deferred revenue a very good kind of liability to have: the business has the customer's cash, earns interest on it, and has a locked-in stream of future revenue.
For analysts, the movement in deferred revenue is a leading indicator. Billings (revenue plus the increase in deferred revenue) show how much customers committed to during the period, ahead of the revenue that will be recognised later.
A subscription business whose deferred revenue is growing faster than its recognised revenue is accelerating; one whose deferred revenue is shrinking is losing renewals even if this quarter's revenue looks fine. The judgement in deferred revenue lies in deciding how and when the obligation is satisfied.
Revenue recognition standards require the business to identify each distinct promise in a contract, allocate the price between them and recognise revenue as each is fulfilled. A bundle of software, installation and support paid for in one sum may be recognised at three different rates.
Getting this wrong, in either direction, is one of the most common causes of financial restatements.
In practice
Real-world examples.
Example
A magazine publisher collects $4 million of annual subscriptions in its autumn campaign and recognises them at one twelfth a month over the following year.
Example
A retailer sells $200,000 of gift cards in December, records them as deferred revenue, and recognises revenue only when the cards are redeemed, with a policy for cards that expire unused.
Example
A consultancy receives a $30,000 retainer for a three-month engagement and recognises $10,000 a month as the work is delivered.
Think of it
“Deferred revenue is like receiving payment for a birthday cake you'll bake next week. You have the money, but you owe a cake until you deliver.
Formula
Calculation
Closing Deferred Revenue = Opening Deferred Revenue + Cash received in advance during the period minus Revenue recognised during the period
Billings = Revenue recognised + Increase in Deferred Revenue
Worked example. A software company sells annual subscriptions. During the year:
- Opening deferred revenue: $2,400,000
- Cash invoiced and collected for new and renewed annual subscriptions: $6,000,000
- Revenue recognised (the portion of all subscriptions earned during the year): $5,400,000
Closing deferred revenue = $2,400,000 + $6,000,000 minus $5,400,000 = $3,000,000
Billings = $5,400,000 + ($3,000,000 minus $2,400,000) = $6,000,000
Deferred revenue grew by 25% while recognised revenue grew by, say, 18% on the prior year: customers are committing faster than revenue is being recognised, and next year's revenue is already partly banked.
Single-contract example. A gym sells a twelve-month membership for $960 on 1 October. On 1 October: debit cash $960, credit deferred revenue $960. Each month thereafter: debit deferred revenue $80, credit membership revenue $80. At 31 December the gym has recognised $240 of revenue and still carries $720 of deferred revenue for the nine months of membership it still owes.Case study
Seen in the real world.
A training company sold two-year course packages for $5,000 and recorded the whole amount as revenue on sale, a practice inherited from its days as a cash-basis sole trader. Sales grew rapidly, reported profit grew with them, and the owner drew large dividends. When growth slowed, revenue collapsed even though the company was busier than ever delivering courses already paid for, and it ran out of cash to pay trainers.
Restating the accounts to defer revenue over the two-year delivery period showed that the company had been recognising about $1.8 million of revenue a year that belonged to future periods and that its true profit had been roughly a third of what was reported. The dividends had been paid out of customers' prepayments. The company survived through a director's loan and a renegotiation with its trainers, adopted proper deferral, and the owner now reads the deferred revenue balance as the measure of what the business owes its students rather than as cash he is free to spend.
Watch out
Common mistakes.
- Recognising revenue when cash is received rather than when the service is delivered, which overstates current profit and understates liabilities.
- Treating deferred revenue as a bad sign because it is a liability. For most businesses it is prepaid, low-cost, committed future revenue.
- Forgetting that the cash from prepayments must fund the future delivery. Spending it all leaves the business unable to serve the customers who paid.
Questions
People also ask.
What is the difference between deferred revenue and accrued revenue?
Deferred revenue is cash received before the work is done (a liability). Accrued revenue is work done before the cash or invoice (an asset).
Is deferred revenue the same as deposits?
A deposit that will be applied to a future sale is a form of deferred revenue. A refundable security deposit that will be returned is a different liability.
How do investors use deferred revenue?
They track its growth as a leading indicator of future revenue and compute billings to see customer commitments ahead of recognition.
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