Revenue generation is the top-most priority for any business as it depicts how much money they actually earned over a specific period. When we say earned money, it means they got paid for delivering customers’ orders successfully and not money received in advance for yet-to-be-delivered items. This is because accounting principles recognize business income only after they have earned money.
The time taken for recognizing revenue until you deliver the product or expenses that you spent for business operations is termed as deferred revenue. It provides transparency in the income statement and is also used to make important decisions related to finances.
So, buckle up folks as we dive deep to understand deferred revenue meaning, why is deferred revenue a liability, and how it differs from recognized revenue and accrued revenue.
What Is Deferred Revenue?
Deferred revenue, sometimes also known as unearned revenue, is the advanced payment made by customers for products, which are yet to be delivered. The basic deferred revenue meaning is the money that you have only received but not earned. When you hand over the product to the customer, then it can be added to the revenue.
Suppose your customer completes the payment of their product prior to the delivery date, it is only considered as deferred revenue liability and not a revenue. This period between purchase and delivery is referred to as deferred revenue or unearned revenue.
Okay, let us have a look at examples to help you understand in detail.
Deferred Revenue Examples
Let us assume that you are a freelance contractor who is responsible for installing septic tanks as per your client’s request. So, you demand some portion of the amount in advance to buy materials or necessary equipment. However, your client agrees to pay the full amount before the installation work has even started. Such early payment done by your client will be considered as deferred revenue until the septic tank is installed.
Similarly, if you are running a SaaS company where you offer your services on a monthly or yearly subscription basis, then clients will pay in advance to avail of subscription plans. Assuming, you have an annual subscription plan of $350 for customers to pay in advance for using your services.
When they make a yearly purchase, only $29 will be added to recognized revenue at the end of the first month, the rest is deferred revenue, which will be moved to revenue as the month progresses. This is because you can only move to revenue once the client has utilized a 12-month-long subscription service.
Deferred vs Recognized Revenue
Deferred revenue is the pre-paid money for a product that you are expecting to get delivered to the customer’s location. On the other hand, recognized revenue is when the money received in advance goes to the revenue column. It confirms that the product has been received by your customers and you got paid, moving the same amount into revenue.
Let’s take an example for clarity. Suppose you have rolled out subscription services where customers purchase an annual plan for $7000 in the month of June. It means $583 will be recognized revenue for each month until the completion of service in the next June. The total amount of $7000 will be considered as recognized revenue only after the customer purchases the subscription plan expires after 12 months.
Deferred Revenue vs Accrued Revenue
The main difference between deferred revenue and accrued revenue is the time taken to complete the delivery or payment. Deferred revenue is formed when money is credited before the product delivery. Whereas, accrued revenue is exactly the opposite of it. Accrued revenue occurs when you have successfully handed over the product to a customer but haven’t received any payment. The due payment for the delivered product is considered as accrued revenue.
For example, you run a digital marketing agency. Your client approves a 1-year long designing project and is ready to pay once the project is completed. So, you will continue providing services for 12 months, but won’t receive money. This due amount for services provided will be recorded as accrued revenue and it will be added to revenue only when the client completes the payment.
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Is Deferred Revenue a Liability?
To some extent, yes. deferred revenue is usually classified as a liability due to the service you still owe to customers. Another reason is to avoid overvaluing the business because investors will only join hands if you have maintained accurate financial records. They won’t take interest in your business if you are considering deferred revenue in your net earnings.
Therefore, accountants will mark this already paid amount as a liability in the main accounting sheet until the product gets delivered. Because if not, there are high chances of clients demanding refunds, which may hamper your overall profit. Nowadays, many industries strictly examine the use of deferred revenue by following laws and regulations. In case of non-compliance, they may impose heavy penalties on your business.
How to Account for Deferred Revenue
Since the principle of accounting considers deferred revenue as liability for prepaid amounts received by you, it is necessary to record it on the accounting sheet. As soon as deferred revenue is generated, it is marked as a prepaid expense by the accountant until the customer receives their product.
You need to update those accounting numbers in your sheet on a daily basis because you never know when the customer will get their product or how long it will take to deliver. Sometimes customers make early payment or late payments, making it very unpredictable to know when you will receive the money. Therefore, it’s better to mark deferred revenue or recognized revenue without considering the timing of the customer’s payment.
How to Manage and Track Deferred Revenue
To manage and track deferred revenue, first of all, you need to ensure your accounting metrics are correct. This is because you can’t manage deferred revenue without accounting reports. You must have accurate reports to manage your business finances no matter if it is deferred or accrued revenue.
In case you are finding it difficult to gather data from hand-written invoices or receipts, you can choose accounting software like Moon Invoice to automate the process. It is sophisticated software that allows you to generate reports in a flash, eliminating the need for manual data collection. It sheds light on how much money is paid or any dues.
Anyways, if you have reviewed the accounting reports, filter out revenues such as deferred or accrued revenue in such a way that they should not consist of taxes or discounts. You can even consider Moon Invoice to customize the data as per your needs. It will not only be easily manageable but also play a pivotal role in driving a profitable business.
Thereafter, run a quick audit process to trace every revenue status and match the data with the customer’s payment details. It will provide transparency to ace the financial management.
How Deferred Revenue Affects Financial Statements
Deferred revenue can affect financial statements in many ways especially if you have a high amount stated as deferred revenue.
Whether you run a SaaS company or eCommerce business, you would collect a large amount of cash before you even deliver the service. In fact, it would only receive money, which can’t be labeled as income.
Now you are familiar with what deferred revenue is, let us look at some factors that will influence the financial statement due to credit in deferred revenue.
Financial Stability
The money counted as deferred revenue will affect your KPIs like reporting timelines and liquidity ratios. It indicates financial stability as you get a fine grip on money received in advance. But remember that it’s only earned if you successfully deliver the purchased item to customers.
Business Valuation
Anyone who is interested in making investments will examine your business health in terms of finance. They will closely monitor the deferred revenue to identify how many products are still left to deliver. It depicts a company’s growth and helps investors decide whether to invest in it or not.
Tax Compliance
Deferred revenue is not only for keeping your accounting reports up to date, but also to compile with tax rules and regulations followed in your state. Since the actual income is not identified because of deferred revenue, your taxable amount will fluctuate until you get rid of deferred revenue.
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Conclusion
Now you know the deferred revenue definition and how it is different from accrued and recognized revenue.
Whether you have deferred revenue or accrued revenue, what actually matters is to provide outstanding customer service and keep track of your cash inflows and outflows. After all, you need to know how much you earn in order to fulfill your financial goals. With Moon Invoice, you need no effort tracking business expenses or generating tax reports. That’s not all, you can do a lot more as far as financial management is concerned. Try your 7-day free trial now.
