Why Is Deferred Revenue Treated As a Liability?

What Is Deferred Revenue?

Deferred revenue is payment received from a customer before a product or service has been delivered. However, the payment is not yet counted as revenue. Deferred revenue, which is also referred to as unearned revenue, is listed as a liability on the balance sheet because, under accrual accounting, the revenue recognition process has not been completed. 

What Is a Liability?

In accrual accounting, a liability is a future financial obligation of a company based on previous business activity. Liabilities are often oversimplified as the debt of a company that must be paid in the future.

An understanding of liabilities is essential to understanding the accounting for deferred revenue. Liabilities arise from a range of business reasons, all of which are tied to situations where a company owes money to another party. Consider the following three situations:

• Situation 1: A company uses electricity and receives a utility invoice.
• Situation 2: A company borrows money to purchase a warehouse.
• Situation 3: A company receives money from a customer but has not yet given the customer any goods.

In all three situations, the company has performed business activity. The result of that business activity is that the company now owes somebody something (i.e. the company owes the electric company a utility payment, the lending institution a mortgage payment, and the customer the goods they paid for). In all three cases, the company now has a liability.

Deferred Revenue and Accrual Accounting 

When a company uses the accrual accounting method, revenue is only recognized as earned when money is received from a buyer and the goods or services are delivered to the buyer. When a company accrues deferred revenue, it is because a buyer or customer paid in advance for a good or service that is to be delivered at some future date.

The payment is considered a liability because there is still the possibility that the good or service may not be delivered or the buyer might cancel the order. In either case, the company would repay the customer, unless other payment terms were explicitly stated in a signed contract.

Over time, when the product or service is delivered, the deferred revenue account is debited and the money is credited to revenue. In other words, the revenue or sale is finally recognized and the money earned is no longer a liability.

Each contract can stipulate different terms, whereby it's possible that no revenue can be recorded until all of the services or products have been delivered. In other words, the payments collected from the customer would remain in deferred revenue until the customer has received what was due according to the contract. 

Deferred Revenues vs. Deferred Expenses

Deferred expenses, much like deferred revenues, involve the transfer of cash for something to be realized in the future. Deferred revenues refer to money received for goods or services to be provided to customers later, whereas deferred expenses refer to money expended for obligations not yet observed. Deferred expenses are expenses paid but not yet incurred. For example, rent payments are deferred expenses. The rent is paid in advance for future use of property or land.

The deferred expense is recorded as an asset on the company's balance sheet (e.g., prepaid rent). The prepaid expense is classified as an asset. That account is debited, while the cash account is credited for the same amount. Once incurred, the expense is recognized on the income statement, and the corresponding asset on the balance sheet is reduced.

Why Is Deferred Revenue Classified As a Liability?

Deferred revenue is classified as a liability because the recipient has not yet earned the cash they received. The company must satisfy its debt to the customer before recognizing revenue.

There are several more specific reasons why deferred revenue is classified as a liability:

1. The company has a debt (liability) to the customer. If the customer demands a refund, the company must return the client's money. Because the company has not yet delivered, the customer must be made whole or their capital must be returned.
2. The company can't recognize revenue before it is earned. Accounting guidance prevents revenue recognition until a company has satisfied recognition requirements. Because the company has not yet performed its contractual obligation, it is not allowed to recognize revenue.
3. It is the most conservative accounting approach. Instead of jumping the gun and recognizing revenue when cash is received, recognizing deferred revenue is a conservative approach that delays recording revenue. This prevents overstating what has been earned or creative accounting techniques.
4. This most closely adheres to the matching principle. Not only is a company more likely to record revenue and an expense in the same period, but this method also strives to have both revenue and expense occur when it most closely matches when the customer receives a benefit.

Example of Deferred Revenue Accounting

A country club collects annual dues from its customers totaling $240, which is charged immediately when a member signs up to join the club. Upon receipt of the payment, the services have yet to be provided. The club would debit cash and credit deferred revenue for $240.

At the end of the first month into the membership, every member has "received" the benefit of having enjoyed the club for one month. Therefore, the country club has satisfied one month (1/12th) of its requirement to offer country club benefits for a full year.

The club would recognize $20 in revenue by debiting the deferred revenue account and crediting the sales account. The golf club would continue to recognize $20 in revenue each month until the end of the year when the deferred revenue account balance would be zero. On the annual income statement, the full amount of $240 would be finally listed as revenue or sales.   

Different Methods Under GAAP

The timing of recognizing revenue and recording is not always straightforward. Accounting standards according to GAAP, or Generally Accepted Accounting Principles, allow for different methods of revenue recognition depending on the circumstances and the company's industry.

For example, a contractor might use either the percentage-of-completion method or the completed contract method to recognize revenue. Under the percentage-of-completion method, the company would recognize revenue as certain milestones are met. Under the completed-contract method, the company would not recognize any profit until the entire contract, and its terms were fulfilled. As a result, the completed-contract method results in lower revenues and higher deferred revenue than the percentage-of-completion method.

A company's financial statements might appear different using one accounting method versus another. Each method would result in a different amount recorded as deferred revenue, despite the total amount of the financial transaction being no different. 

The Bottom Line

Deferred revenues are the payments received by customers for goods or services they expect to receive in the future. Until the service is performed or the good is delivered, the company is indebted to the customer, making the revenue temporarily a liability. Once earned, the revenue is no longer deferred; it is realized and counted as revenue.