For small business owners, getting paid by a client feels amazing. But don't spend that cash just yet. There can be a difference between cash in hand and revenue the business hasn't yet earned. That difference is deferred revenue. Deferred revenue is an account on the books that is only used by businesses that use the accrual basis of accounting.
What is deferred revenue?
Deferred revenue, sometimes referred to as unearned revenue, is payment your business receives for products or services that will be delivered later.
For example, say you own a bookkeeping company and charge a client $350 per month for bookkeeping services. You collect $350 on March 1 but don't complete their bookkeeping or deliver their financial statements for March until the end of April. If the client cancels their service before you perform the work, you must return their money. So even though you collected cash, you haven't yet earned it—it should be shown as a liability on your financial statements rather than revenue.
Why recognize deferred revenue?
Deferred revenue is only used in accrual accounting because companies that use the accrual basis recognize revenue when earned. Deferred revenue is different than accounts receivable. Deferred revenue is payments received in advance of services being provided. Accounts receivable are payments billed for services that have already been provided. Companies that use the cash basis of accounting don't use the deferred revenue account because they recognize revenue when cash is received regardless of when it's earned.
Besides being a requirement of the matching principle of accrual accounting, recognizing deferred revenues is a good business practice because it prevents over-valuing your business. It's easy to look at the revenues or net income on your Profit & Loss Statement and think your business is doing well. However, if a large portion of those revenues haven't been earned yet and you have to issue refunds to customers, it could destroy your business.
Recognizing deferred revenue helps you avoid spending money you have yet to earn or misleading lenders, investors, and others who rely on your financial statements.
How to record deferred revenue
To help you understand how to record deferred revenue in your accounting records, here's an example of the accounting entries you would make when deferred revenue is received and then reversed.
Returning to the example above, on March 1, when you receive the client's payment of $350, you would debit cash for $350, and credit deferred revenue for the same amount.
On April 29, you complete the client's bookkeeping and issue their March financial statements. At that point, you've earned the $350 they paid on March 1, so you make an adjusting journal entry to debit deferred revenue for $350 and credit revenue for the same amount.
Where does deferred revenue appear in the financial statements?
Deferred revenue is a liability, so it appears on the balance sheet. Usually, deferred revenue will be earned within one year, so it's shown as a short-term liability.
If, for some reason, you receive payment from a customer and won't earn the revenue for one year or more, that deferred revenue should be shown as a long-term liability on your financial statements.
Deferred revenues are common in insurance, software as a service (SaaS), and other industries where customers make up-front payments in exchange for products and services delivered over time.
Accounting for deferred revenues is more complicated and time-consuming than simply recording all cash receipts as revenues. But it's a more accurate way to account for income your company hasn't yet earned. If your company issues financial statements based on generally accepted accounting principles (GAAP), then accrual accounting and deferred revenue are required. It may be a good idea to consider using accounting software to track deferred revenue accounts.
Find out more about Business Taxes