What Is Deferred Revenue, and Is It Worth the Risk?

We all want to get paid, and getting paid in advance may seem ideal. But money received before it's earned is considered an accounting liability — one that's quite complex to manage at scale.

This is known as deferred revenue, and understanding it is critical to managing an organization's finances responsibly. Whether you're running a subscription service or collecting deposits, deferred revenue management has a direct impact on your company's financial health and credibility with investors.

Let's take a closer look at what deferred revenue is, where it applies, and how to manage it.

What you'll learn:

• What is deferred revenue?
• Why deferred revenue is considered a liability
• Examples of deferred revenue
• Accounting for deferred revenue
• Best practices for tracking and accounting for deferred revenue
• Use the right tools for accounting for deferred revenue
• Deferred revenue FAQs

When calculating revenue, deferred revenue refers to funds or payments a company receives in advance for products or services that have yet to be delivered. This is also commonly referred to as "unearned revenue." Revenue is only "earned" and reflected on your company's income statement once you've delivered what you've promised to your customers.

Deferred revenue is common in certain business models, such as subscription-based services and software-as-a-service (SaaS) companies. It also applies to traditional retailers that offer gift cards and service providers who require upfront deposits, like contractors, lawyers, and wedding planners. Understanding how deferred revenue fits into your specific business model is crucial for proper revenue recognition best practices and effective financial planning.

Deferred revenue directly affects your balance sheet as a current liability (fulfilled within one year) or a long-term liability (fulfilled after one year). This distinction is important for tax purposes and influences how much income you can include on financial statements. As products and services are delivered, this liability decreases while revenue on the income statement increases proportionally.

Deferred revenue is classified as a liability under accrual accounting because it represents an obligation for your company to deliver goods or services in the future. Even though payment has been received, the money has not yet been earned. If your company fails to deliver, you may have to refund the money, which is why deferred revenue is considered a liability.

Once the work is completed, you can recognize the revenue on your income statement. Until then, it must be categorized as "unearned" to reflect your true financial status and to align with Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS).

Some revenue models routinely take on this liability for either primary or secondary revenue streams. Common examples include:

• Subscription and streaming services: Many SaaS software companies, retailers, telecommunications companies, and streaming services in the entertainment industry offer subscriptions for content, products, or services in advance of delivery. For example, if you sign up for a streaming service and pay for an annual subscription, the streaming service can't count the fee as revenue until you've spent a year watching all your favorite TV shows.
• Travel and hospitality: Many hotels, airlines, and car rental companies charge a partial (or sometimes full) fee upon booking and receive the balance after the travel takes place.
• Membership- or tuition-based businesses: Businesses like gyms, country clubs, or educational institutions may require payment upfront as a means of securing your space or membership. This ensures that the organization consistently earns money even if you don't consistently use the service or end up never using it.
• Rental or leasing agreements: Rental payments for real estate or auto leases are typically collected one or more months in advance and are also considered deferred revenue.
• Insurance: Similarly, most forms of insurance are prepaid but are typically only used if needed. While most insurance is billed monthly, some forms are paid on an annual basis.
• Independent consultants or professionals: Anyone who works on retainer, such as a private lawyer, physician, or business consultant, etc., is typically paid in advance with an agreement to deliver up to a set amount of work within a given period. This may also include tutors, music teachers, house cleaners, and others if they package and bill their work in advance.
• Gift cards: Payment received from the sale of a gift certificate doesn't qualify as earned revenue and is considered a liability until the gift certificate has been redeemed.

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Let's go through a detailed example to illustrate how deferred revenue is properly accounted for on financial statements.

Imagine a baking school named Wonderful Cakes Academy (WCA). A baking course at WCA consists of 12 sessions over six months, with two classes each month at $100 per class. The course runs from July to December, and WCA collects payments from students in June. This situation exemplifies deferred revenue because full payment must be received the month before classes begin.

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When a student pays $1,200 in June, WCA records this transaction as:

• Debit: Cash $1,200
• Credit: Deferred revenue $1,200

On the balance sheet, this appears as:

• Assets: Cash increases by $1,200
• Liabilities: Deferred revenue increases by $1,200
• No impact on the income statement yet

As WCA delivers two classes each month ($200 worth of services), the school recognizes revenue as:

• Debit: Deferred revenue $200
• Credit: Revenue $200

This process continues, with the deferred revenue liability decreasing while the earned revenue increases by $200 each month.

By the end of December, once the course is finished, WCA will have:

• Recognized the entire $1,200 as earned revenue over the six-month period
• Reduced the deferred revenue liability to zero
• Revenue recognition accurately represents service delivery

This systematic approach guarantees adherence to revenue recognition best practices and delivers accurate financial information to stakeholders throughout the service delivery period.

Deferred revenue is easier for some businesses to manage and track than for others. For example, when you lease a car or enter into a rental or insurance agreement, the business typically earns the revenue the following month, after the customer's coverage period has ended and the monthly payment is complete. However, some businesses allow customers longer timeframes to redeem a product or service.

Here are a few best practices to consider:

Use dedicated accounting software or tools to manage revenue cycles that can automate tracking and ensure visibility of deferred revenue balances, recognition schedules, and remaining obligations. It's important to know which services are pending, when they're scheduled for delivery, and any potential delays that might affect recognition at any time.

Maintain a clear audit trail and conduct monthly reconciliations of deferred revenue accounts to ensure accuracy and identify any discrepancies early. Classifying deferred revenue as either a current liability (obligations due within one year) or long-term liability (obligations beyond one year) provides an accurate balance sheet presentation and improves financial planning.

Ensure you have contingency plans in place, as any company can be affected by unforeseen events. Factors such as weather, political instability, data breaches, public health crises, or damage to brand reputation on social media can swiftly and adversely impact revenue. Proactively establish protocols for handling cancellations, refunds, or service modifications. Understand when deferred revenue must be returned and when it can be applied to alternative services.

Strong communication among sales, product, and accounting or revenue operations teams is essential to ensure clarity around the delivery status of goods and services. The accounting team needs to know exactly when products and services are expected to be delivered. Sales teams should promptly notify accounting of any known delays, cancellations, or scope changes to prevent recognition errors and maintain accurate financial reporting.

Consider implementing a revenue operations solution that integrates with your current tools to automate revenue tasks. Platforms that manage your complete revenue lifecycle make it easier to follow best practices and keep detailed records of contracts, service agreements, and delivery confirmations to meet audit requirements. And don't forget to provide training for any new tools you adopt, so your accounting team understands how to manage unearned revenue and other aspects (such as usage-based pricing) within the system you choose.

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To manage deferred revenue effectively, it's important to exercise financial discipline, plan cash usage carefully, and coordinate operations across business units — which is not an easy task. Fortunately, there are revenue management tools and resources (including revenue recognition standards and revenue recognition principles) that help simplify accounting for deferred revenue and prevent advance payments from burning a hole in your wallet.

The right technology solutions can automate much of the tracking and recognition process, reducing errors and freeing your team to focus on strategic activities. Look for platforms that integrate with your existing systems and provide real-time visibility into your deferred revenue recognition schedules and obligations, supporting your revenue lifecycle management objectives.

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