What is Deferred Revenue?
How Does Deferred Revenue Work?
For reporting purposes, a business must classify all items as either assets or liabilities. Cash, for example, is usually considered an asset. However, if a business receives a prepayment on an order, the prepayment is classified as a liability because the payment represents something that is not yet earned and is therefore owed to the customer. Upon delivery of the good or service to the customer, the deferred revenue is reclassified as an asset.
An example of deferred revenue is when a cleaning company accepts the prepayment of its monthly fee for its services in advance for a whole year. The company agrees to provide cleaning services for that year. If the cleaner cannot provide the service at any point during that year, the "unearned" fee must be refunded. The "unearned" portion of that fee is treated as deferred revenue until the monthly service is performed. At that point, the fee is earned and is converted into an asset. Other examples of deferred revenues are advance payments to a software company before the software is completed, advance payment to a plumbing contractor before the installation is completed, or prepayment for an annual subscription to an online service. In each of these cases, the payment is treated as deferred revenues.
Why Does Deferred Revenue Matter?
Deferred revenue is important in accurate reporting of assets and liabilities on a company's balance sheet. It protects against treating unearned income as an asset, and guards against overvaluing the company's net worth. While cash is usually the safest asset a company owns, not all cash is equal: Cash that is classified as deferred revenues is at risk until the work is performed. Deferred revenues are important to a company because they finance operations without encumbering other company assets or drawing on a credit line.