Deferred Revenue and Current Liability Explained in Simple Terms

Deferred revenue is a type of asset that represents payments received by a company before it has earned the related revenue. This can happen when a customer pays for a service or product in advance, such as a subscription or a deposit.

Think of it like a pre-paid gym membership. If you pay for a year's worth of gym membership upfront, the gym has received the payment but hasn't earned the revenue yet because you haven't used the service.

Deferred revenue is typically classified as a current asset because it's expected to be earned within a short period of time, usually within a year.

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Deferred revenue is a type of liability that represents payments received from customers for goods or services that have not yet been delivered or provided.

This is in contrast to current liabilities, which are debts or obligations that must be paid within a short period of time, typically within one year.

Deferred revenue is often seen in situations where a company offers a subscription-based service, such as a monthly software plan, and the customer pays upfront for a year's worth of service.

This type of liability is also common in industries where customers pay for goods or services in advance, such as in the case of a pre-paid gym membership.

The key characteristic of deferred revenue is that it represents a future obligation to deliver goods or services, rather than a current debt that must be paid immediately.

If this caught your attention, see: Accrued Service Revenue

There are two main accounting systems: cash accounting and accrual accounting. Cash accounting recognizes revenue and expenses when they are received and paid, respectively, with no deferred revenue.

In accrual accounting, revenue is recorded when it is earned, not when the cash is received. This means you report earned revenue in the accounts receivable journal, which is an asset.

Accrual accounting gets complicated when clients haven't paid their bills yet. You still record the earned revenue, but it's listed as an asset, specifically in the accounts receivable journal.

Here's an interesting read: Accounts Receivable vs Deferred Revenue

Accrual accounting also deals with unearned revenue, which is recorded in the deferred revenue journal, a liability. This is the opposite of earned revenue, where you've received revenue from a client but not yet earned it.

Here's a comparison of the two accounting systems:

Deferred revenue shows up in two places on the balance sheet: as an asset, representing cash received from clients, and as a liability, indicating that the company still owes the client its services.

Most prepaid contracts are less than one year long, so deferred revenue is generally a current liability. However, if clients pay for multiple years of service upfront, part of the deferred revenue will be considered a long-term liability.

Deferred revenue does not appear on the income statement, but rather is transferred to the revenue account as the company fulfills its part of the contract.

The statement of cash flows shows the money flowing into or out of the company, with deferred revenue appearing as a positive number in the operating activities part of the cash flow statement.

Expand your knowledge: Deferred Revenue Cash Flow Statement

Here's a breakdown of where to find deferred revenue in a company's financial statements:

To track potential manipulations around deferred revenue and revenue recognition, two ratios are suggested:

A sequential increase in any of these ratios could indicate aggressive revenue recognition. If an increase is substantial either year-over-year or by quarter, it may be a warning sign that management is masking current revenue struggles by drawing down on deferred revenues.

Let's take a look at a real-life example of how deferred revenue is presented in financial statements. Cognizant Technology Solutions ($CTSH) reports its deferred revenue in the Consolidated Statements of Financial Position (balance sheet). You can find this line item by searching for "deferred revenue" in their latest 10-k filing.

In the notes to the financial statements, Cognizant breaks down both unrecognized (deferred) revenues and amounts being recognized to revenue in the given year. This helps to clarify how much of the deferred revenue liability was recognized in revenue and how much was added to the balance.

A unique perspective: Difference between Financial Accounting and Management Accountant

Cognizant's balance sheet reconciliation shows that deferred revenue is comprised of both current and noncurrent liabilities. For 2019, the deferred revenue balance was $336 million, which is a decrease of $12 million from the previous year. This decrease is due to $261 million of deferred revenue liability being recognized as revenue in the income statement.

Here's a breakdown of the changes in deferred revenue:

The Consolidated Statement of Cash Flows also shows changes in deferred revenue, but this number may not necessarily reconcile with the balance sheet changes due to various factors such as foreign currency adjustments or new deferred revenues collected.