how deferred revenue works
deferred revenue is recognized as a liability on the balance sheet of a company that receives an advance payment because it has an obligation to the customer in the form of the products or services owed the payment is considered a liability to the company because there s a possibility that the good or service may not be delivered or the buyer might cancel the order the company would have to repay the customer in either case unless other payment terms were explicitly stated in a signed contract contracts can stipulate different terms whereby no revenue may be recorded until all of the services or products have been delivered the payments collected from the customer would remain in deferred revenue until the customer has received in full what was due according to the contract generally accepted accounting principles gaap require certain accounting methods and conventions that encourage accounting conservatism that ensures that the company is reporting the lowest possible profit a company that s reporting revenue conservatively will only recognize earned revenue when it has completed certain tasks to have full claim to the money and when the likelihood of payment is certain deferred revenue is often gradually recognized on the income statement to the extent that the revenue is earned as a company delivers services or products categorizing deferred revenue as earned revenue too quickly or simply bypassing the deferred revenue account altogether and posting it directly to revenue on the income statement is considered aggressive accounting and effectively overstates sales revenue deferred revenue is typically reported as a current liability on a company s balance sheet because prepayment terms are typically for 12 months or less 2the portion of the payment that pertains to services or products to be provided after 12 months from the payment date should be classified as deferred revenue under the long term liability section of the balance sheet if a customer made an up front prepayment for services that are expected to be delivered over several years example of deferred revenuedeferred revenue has become more common with subscription based products or services that require prepayments unearned revenue can be rent payments that are received in advance prepayments received for newspaper subscriptions annual prepayments received for the use of software and prepaid insurance this form of revenue has become mainstream as an annual payment to premium membership for accounts such as amazon prime zoom adobe google suite services and ai based services all belong to this category of advanced payment and are encouraged through a discount given by the companies for annual payment versus monthly payment of these subscriptions the other company involved in a prepayment situation would record their advance cash outlay as a prepaid expense or an asset account on their balance sheet the other company recognizes its prepaid amount as an expense over time at the same rate as the first company recognizes earned revenue consider a media company that receives a 1 200 advance payment at the beginning of its fiscal year from a customer who s purchasing an annual newspaper subscription upon receipt of the payment the company s accountant records a debit entry to the cash and cash equivalent account and a credit entry to the deferred revenue account for 1 200 the company sends the newspaper to its customer each month and recognizes revenue as the fiscal year progresses the accountant records a debit entry to the deferred revenue account monthly and a credit entry to the sales revenue account for 100 the entire deferred revenue balance of 1 200 has been gradually booked as revenue on the income statement at the rate of 100 per month by the end of the fiscal year the balance is now 0 in the deferred revenue account can you have deferred revenue in cash basis accounting no revenue in cash basis accounting is reported only after it s been received expenses in cash basis accounting are recorded only when they re paid as well 3