In this article, you will learn:
- What type of transaction creates Deferred Revenue for a Business.
- Why we record Deferred Revenue as a Liability.
- The four steps of a Deferred Revenue Transaction.
- How to record a Deferred Revenue Transaction (Debits & Credits).
- The Cash Flow impacts of Deferred Revenue.
Estimated reading time: 12 minutes
- A Business records Deferred Revenue when a Customer prepays for a future good or service.
- We record Deferred Revenue as a Liability because it reflects the obligation to deliver a good or service to a Customer in the future.
- Deferred Revenue creates a short-term Cash Flow benefit, but it ultimately represents a good or service owed to a Customer.
Why Does Deferred Revenue Matter?
Deferred Revenue is a critical concept to master if you are aiming for (or currently working in) Finance.
Understanding Deferred Revenue is essential because it can significantly impact the Cash Flow of a Business.
In this article, we will provide a variety of illustrations to explain Deferred Revenue and its implications for the Cash Flow of a Business.
Deferred Revenue in Interviews
Interview questions related to Deferred Revenue are quite common because it is a tricky concept that interviewers often use to trip up prospective candidates.
A few common interview questions on Deferred Revenue are:
- What is Deferred Revenue?
- How is Deferred Revenue created?
- What is the Cash Flow impact of Deferred Revenue?
- Is Deferred Revenue a current or non-current liability?
To answer these questions, you will need to understand:
- The fundamental nature of Deferred Revenue.
- The Cash Flow impacts of Deferred Revenue.
After reading this article, you will nail all of the Interview Questions above.
Let’s dive in!
How does a Business Create Deferred Revenue?
Let’s begin here by answering a few critical questions:
- What is Deferred Revenue? or How do we define Deferred Revenue?
- How does Deferred Revenue arise for a Business?
Deferred Revenue is created when a customer pays in advance to receive future goods or services from a Business.
If you’re thinking, ‘Why on earth would a customer pay in advance of receiving a good or service?’, then you’re on the right track.
Let’s look at an everyday example where we might prepay for a future service.
Real Life Deferred Revenue Example: Apple Music Subscription
To begin with, Customers typically don’t pay ahead of time without some form of enticement.
In most cases, Customers agree to pay in advance because they receive a discount.
A great real-life example of this is paying in advance for a year-long subscription to a service like Apple Music.
For an annual subscription, a customer would normally pay $10 per month ($120 per year) for Apple Music.
However, if a customer is willing to pay for a full year in advance, the price is just $99.
But how do we record a transaction when a customer prepays for a future service?
Why Don’t We Record Customer Prepayments As Revenue?
The key thing to understand about the transaction in the previous section is that we can’t record the entire $99 as Revenue off the bat.
That is because, in Accounting, we don’t record Revenue until a transaction is ‘earned and substantially complete.’
As a result, we move the expense to the Balance Sheet as a Liability until the sale is ‘earned.’
We then wind the Liability down when the Company delivers the good or service to the Customer.
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Why Do We Record Deferred Revenue as a Liability?
A common question that comes about at this point is, ‘why do we record Deferred Revenue as a Liability?.’
To answer that questions, let’s revisit the fundamental concept of a Liability.
With any Liability, we receive a benefit today but owe payment in the future.
With Deferred Revenue, the Company receives a benefit (i.e. Cash) now from the Customer prepayment.
However, the Company owes deliver of the good or service to the Customer in the future.
Because the Business owes the delivery of the future good or service, we record a Liability.
Now that we have covered the Fundamentals of Deferred Revenue, let’s go through the four steps of recording a Deferred Revenue transaction.
Recording Deferred Revenue in Four Steps
First, a Business creates Deferred Revenue when a customer prepays for a good or service that the Customer will receive in the future.
Second, after the Customer makes the prepayment, the Business now owes that Good or Service to the customer.
As a result, we record Deferred Revenue as a Liability (owed by the Company) until the Business delivers the good or service to the Customer.
Third, at some point, the Business delivers the Good or service to the Customer.
Fourth, once the Business delivers the good or service to the customer, we eliminate the Liability and record Revenue reflecting the completion of the sale.
Now let’s take a look at how we would record the above transactions in terms of Debits and Credits.
Journal Entries for Deferred Revenue
Below we walk through the two typical Journal entries for Deferred Revenue.
How to Record Deferred Revenue Journal Entries
- Customer Makes Prepayment for Future Delivery of Good or Service
Debit Cash to reflect the inflow of Cash to the Business.
Credit Deferred Revenue to reflect the fact that the Company now owes the customer a Good or Service in the future.
- Good or Service is Delivered/Earned
When the good or service is delivered to the customer, we Debit the previously recorded Liability to reflect the fact that the prior obligation has been satisfied.
And we Credit Revenue to reflect that the Good or Service has been delivered and that the transaction is now earned and substantially complete.
Now let’s switch gears and look at how Deferred Revenue impacts Working Capital and Cash Flow.
How does Deferred Revenue impact Working Capital?
From an Accounting perspective, we calculate Working Capital as Current Assets (excluding Cash) – Current Liabilities.
In substance, Working Capital simply reflects cash tied up in a Business.
In the formula above, we can see that Deferred Revenue lowers the Working Capital required (i.e. ‘tied up cash’) for a Business.
Or, said differently, when a customer makes a prepayment, the prepayments provide cash inflow to the Business.
This cash inflow is clearly a nice short-term benefit.
However, as we’ll see in the next section, this cash inflow from Deferred Revenue is a double-edged sword.
The Impact of Deferred Revenue on Cash Flow
As we said, Deferred Revenue arises when a customer prepays for a future good or service.
The prepayment creates a Cash inflow for the Company which helps the Business.
However, the Business now owes that good or service to the Customer.
So, in the end, Deferred Revenue is a double-edged sword.
On the one hand, Deferred Revenue provides a short-term boost to Cash Flow.
But on the other hand, it creates an obligation that the Business must now satisfy.
For a deeper dive, you can read more about how Deferred Revenue can provide essentially free funding in our Negative Working Capital article.
For now, to make the concept of Deferred Revenue more tangible, let’s look at how Deferred Revenue impacts a real Company.
Deferred Revenue Example: Salesforce.com
In real life, Software as a Service (SAAS) Businesses typically has significant Deferred Revenue.
In this example, we’ll look at Salesforce.com, one of the largest Customer Relationship Management (or ‘CRM’) SAAS businesses.
The high level of Deferred Revenue arises because SAAS businesses typically offer customers significant discounts in return for paying in advance for their services.
We can find the total balance of Salesforce.com’s Deferred Revenue on the Company’s Balance Sheet.
In Salesforce’s Balance Sheet, we can see that the Company has received nearly $13 billion in Customer Prepayments for which it owes future services.
If we switch over to the Cash Flow Statement, we can see that Unearned Revenue (i.e. ‘Deferred Revenue’) has created $1.5-1.9 billion of annual incremental Cash Flow for Salesforce year in the last three years.
Said differently, ~40-45% of the Company’s Cash Flow from Operations has come from Deferred Revenue!
As you can see, Deferred Revenue provides a major benefit to Salesforce.com’s business by generating significant excess Cash Flow.
However, as we said earlier, Salesforce now owes those services to customers in the future.
Now that we’ve looked at a real-life example with Saleseforce.com, let’s now answer a few common questions that pop up related to Deferred Revenue.
Common Question #1: Deferred Revenue vs Unearned Revenue vs Unearned Income
In Finance, we often have multiple names for the same concept, which is understandably quite confusing.
In the case of Deferred Revenue, Unearned Revenue, and Unearned Income, they all mean the same thing.
Despite seemingly different-sounding names, these three terms represent the same underlying concept.
Common Question #2: Do we always record Deferred Revenue as a Current Liability?
Another common question is whether or not Deferred Revenue is always a Current Liability.
Before we answer the question, let’s quickly recap the difference between a current vs non-current Liability.
A Current Liability is a Liability that we must pay within 12 months.
On the other hand, a Non-Current Liability reflects when we don’t pay off an obligation until a year or more into the future.
While it is not very common, customers may sometimes pay in advance for a good or service that they won’t receive for more than 12 months from the date of prepayment.
So, in short, Deferred Revenue can be both a Current Liability and a Long-Term (or Non-Current) Liability.
Wrap-Up: Deferred Revenue
Hopefully, you now have a much better understanding of the ins and outs of Deferred Revenue.
As we said above, Deferred Revenue is important because it can have significant positive or negative Cash Flow implications for a Business.
Let us know if you have any questions in the comments below. We’d love to hear from you!
About the Author
Mike Kimpel is the Founder and CEO of Finance|able, a next-generation Finance Career Training platform. Mike has worked in Investment Banking, Private Equity, Hedge Fund, and Mutual Fund roles during his career.
He is an Adjunct Professor in Columbia Business School’s Value Investing Program and leads the Finance track at Access Distributed, a non-profit that creates access to top-tier Finance jobs for students at non-target schools from underrepresented backgrounds.
Frequently Asked Questions
Deferred Revenue is created when a customer prepays for a future good or service. Because we only record Revenue when its earned and substantially complete, we initially record Deferred Revenue as a Liability (reflecting the value of the good or service to be delivered).
When the business delivers the good or service to the Customer, we eliminate the original Liability and record Revenue.
We record Deferred Revenue as a Liability upon prepayment by the Customer.
When the business delivers the good or service owed to the customer, we then record Revenue and simultaneously eliminate the original Liability that we created at the time of the Customer prepayment.
Deferred Revenue reflects an obligation to deliver goods or services to a Customer in the future. As a result, Deferred Revenue is recorded as a Liability.