Deferred revenue is an essential accounting practice for any scenario where a customer prepays for goods or services. Any team operating a subscription-based business needs to understand its nuances. Whether you’re an established SaaS enterprise or migrating your business to a subscription-billing model, you must understand how to navigate complex revenue recognition while maintaining compliance with accounting standards. Deferred revenue is a critical piece of that puzzle, and this blog clarifies what it is and why it’s reported as a liability.
What is deferred revenue?
Deferred revenue refers to advance payments made by a customer for goods and services the company will provide in the future. It’s also known as unearned revenue; since the obligation has yet to be delivered, the payment hasn’t been ‘earned. Deferring revenue appropriately is a key component of revenue recognition for subscription billing.
When do you need to defer revenue?
Following US GAAP guidelines for accounting conservatism, companies must defer revenue anytime there is a delay between when the customer pays and when the obligation is fulfilled. If the good or service is then undelivered or cancelled, the company may owe the money back to the customer.
It’s best practice to recognize revenue as it’s earned and track customer behaviour with a customer aging report. When customers pay in advance, it’s particularly important to keep accurate reports of unearned revenue, so that your company does not invest or use more of its resources than are strictly available.
What is the difference between deferred revenue and accrued expenses?
Deferred revenue and accrued expenses both appear under liabilities on a company’s balance sheet. While deferred revenue refers to money that the business has received in advance of providing goods and services, accrued expenses are money the business owes for goods and services it has already received. One way to think of it is that the two are inverses of each other.
What types of businesses record deferred revenue?
Deferred revenue is commonly held by any business where customers pay in advance for goods and services. Popular examples of businesses with deferred revenue include:
- Subscription-based businesses (SaaS companies, magazines, subscription boxes)
- Organizations with membership fees (professional associations, private clubs, gyms)
- Companies that collect rent
- Prepaid insurance
- Professionals who collect retainers (consultants, lawyers, developers)
- Professionals who collect an up-front deposit
- Hospitality services (airlines, hotels, housekeeping)
Further reading: The complete guide to 8 SaaS pricing models to grow subscriptions
Why is deferred revenue reported as a liability?
According to the US GAAP standards regarding revenue recognition, when customers pay for products or services in advance, companies must record the income as a liability on their balance sheet rather than revenue on their income statement. This accounting treatment demonstrates that the company still owes the customer and protects the company from overstating its value.
In the event that the order is cancelled or cannot be delivered according to the original plan (ex. natural disaster, supply chain shortages, bankruptcy), the company must repay the customer their prepayment. Revenue is also taxed in the same period that it’s recognized, so if there’s even a slight chance you’ll have to repay the customer, it’s best to defer the revenue until the goods/services are delivered.
Is deferred revenue recorded as a debit or credit on the balance sheet?
Deferred revenue is a liability until the products or services are delivered, so you will make an initial credit entry under current or long-term liability, depending on whether the sale is under twelve months. You will debit the sales account and credit the deferred revenue account as you earn the revenue.
This process may seem simple, but it can become complex when applied to recurring revenue. If you’re looking for more information, our blog also covers best practices for recognizing revenue under ASC 606 and IFRS 15 and has a special primer for SaaS companies on ASC 606.
Example | How to account for deferred revenue from an annual subscription
Assigning a specific adjustment account to track deferred revenue enables you to record unearned income as a liability and accurately recognize revenue as you fulfil the performance obligation(s) in your contract.
For this example, let’s assume that you’ve secured an annual subscription with a client at a flat rate of $18000. The client pays the full amount upfront; however, you cannot recognize the full $18000 until the service has been provided. You must evenly divide the total across one year, which is the duration of the contract, and recognize the revenue in increments.
For the first month, you recognize $1500 and defer the remaining $16500 to an adjustment account. For each month after that, you’ll credit the deferred revenue account and debit the sales account $1500.
Introducing Subscription Billing Suite
Complex revenue recognition is unavoidable in any business model that employs subscription billing, but it doesn’t have to be complicated. A robust subscription management solution like Subscription Billing Suite can simplify the process by automating deferred revenue and enabling you to remain compliant with accounting guidelines such as ASC 606 and IFRS 15. Your accounting team can focus less on repetitive, mundane tasks and redirect their attention to what matters.