Deferred Revenue as a Liability: Key Insights for Financial Analysts and Investors
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Aja McClanahan
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Nupur Gambhir
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Whether you are a small business owner trying to get an accurate picture of cash flow or a Main Street investor examining financial statements to pick stocks, understanding deferred revenue can help you better analyze a company’s financial condition. Here’s a quick guide on deferred revenue and its role in an entity’s overall financial picture.
What is deferred revenue?
Deferred revenue, also called unearned revenue, is recognized as a liability on a company’s balance sheet. Typically, you’ll see deferred revenue on the balance sheet when a business receives customer payments for goods or services that have not yet been delivered or completed.
Since this revenue has not yet been earned because goods and services have not yet been delivered, the company records the payment as a liability until the transaction has been completed, i.e., services rendered or goods delivered. It’s considered a liability because there’s a chance that the company may not fulfill its obligations, which means it will still be indebted to the customer who’s already paid.
For instance, subscription-based businesses, such as magazines or software services, often collect fees in advance, and as the service period progresses, they gradually recognize the related revenue. Understanding deferred revenue can be critical to a company’s financial health, operating and income projections.
How does deferred revenue work?
Deferred revenue works by acknowledging the timing difference between receiving payment and delivering goods or services. When a company receives an advance payment, it must record it as a liability on the balance sheet under deferred revenue. This entry stays on the balance sheet until the business fulfills its obligation by delivering the agreed goods or services. Once the goods and services are rendered, the company transfers the proportionate amount of deferred revenue to actual revenue, reflecting earned income on the income statement.
Deferred revenue example
As an example, let’s consider a software company that sells an annual software subscription for $1,200. The full amount is recorded as deferred revenue when a customer pays for this service. As each month passes, $100 ($1,200 / 12 months) is recognized as revenue, gradually reducing the deferred amount recorded on the company’s balance sheet as a liability.
Deferred revenue in accounting standards
Olivia Thompson is a business development specialist at ChamberofCommerce.org. She says that properly acknowledging and reporting deferred revenue is a requirement to comply with Generally Accepted Accounting Principles (GAAP.) She explains, “Following U.S. GAAP, businesses have to defer revenue whenever there’s a gap between when a customer pays and when the actual service or product is delivered. That’s because if something doesn’t work out and the service or product isn’t shipped, or it gets canceled, the company might have to refund that money.”
Recognizing deferred revenue also helps businesses adhere to the accrual accounting method, which can be a more accurate way to reflect a company’s financial situation. Accrual accounting principles dictate that income is recognized when earned, not when cash is received, the opposite of cash basis accounting, which recognizes revenue only when cash is received.
Reporting deferred revenue on financial statements
Deferred revenue is first reported on a company’s balance sheet as a liability because it reveals the business’s obligation to deliver a product or service in the future. As services or goods are provided, this amount transitions to the income statement when the service is rendered and the transaction is complete.
How is deferred revenue treated for tax purposes?
The tax implications of deferred revenue also make sense because tax liabilities are typically not triggered until revenue is recognized. The primary advantage of this tax reporting method is that it allows a business to delay tax liabilities to future periods, providing it with additional cash that can be used for investment or to expand the business.
Deferred revenue in financial analysis
Deferred revenue can be a useful indicator for financial analysts and investors since it gives clues about a company’s future revenue streams and the sustainability of its business model. A large amount of deferred revenue on a balance sheet may suggest a healthy demand for a company’s products or services, indicating a potentially steady cash flow.
However, analysts may also consider how efficient a company is in meeting its stated deferred revenue obligations, as consistently high deferred revenue could suggest potential delivery delays or fulfillment issues. Plus, a healthy dynamic between these figures would signal that income is recognized effectively without overstating earnings.
Importance of deferred revenue
Understanding deferred revenue can be helpful for someone about to purchase a business or invest in a company’s stock, as this figure can provide deeper insight into a company’s financial health.
Investors analyzing financial statements may be interested in deferred revenue, which can influence stock valuation as it represents future income potential. Daniel Milan is a managing partner at Cornerstone Financial Services. He explains that “this is important to understand in order to not artificially inflate a company’s profitability.”
Nathan Redman-Brown is a wealth advisory analyst at Bordeaux Wealth Advisors. He presents the following illustration to help us understand this concept from an analyst’s perspective: “For the same price, would you rather (A) buy a business that just received $100k in cash for preorders or (B) buy a business that has a “projection” of $105k of sales? Even though the projected number of company B is higher, company A has already captured the cash.”
He continues, “Higher unearned revenues traditionally indicate contractually guaranteed revenue flows with low variability. Earnings per share (EPS) could be the same for the two companies in 2024, but an investor could look at the 2025 (and beyond) balance sheet to see the incoming revenue recognition from deferred revenue and make a better-informed decision on the future floor EPS of the companies.”
In the world of mergers and acquisitions, some valuators view unearned revenue as “bond-like, where they estimate how much the new buyer could lower the cost of service delivery for deferred revenue, and then they discount that cash flow to arrive at the deferred revenue component addition to the business price,” according to Mr. Redman-Brown.
How does a company track deferred revenue?
It’s important to note that mismanagement or inaccurate reporting can result in distorted financial statements, affecting business evaluations and operational decisions. Proper tracking and management of deferred revenue are important elements of correctly recognizing it in financial statements. Technologies and accounting solutions, such as automated revenue recognition systems, may assist in managing these financial obligations efficiently.
Mr. Redman-Brown explains, “This is important to track as it is a leading indicator of the health of a business. For companies that have a large deferred revenue balance, tracking this amount is just as important as tracking the reported revenues. When the deferred revenue balance drops, there is a very high likelihood that future revenues will decline as well.”
Bottom line
Proper tracking and recognition of deferred revenue play an important role in accurate financial reporting. Additionally, it can help with operational efficiency and potential tax strategies. By analyzing deferred revenue trends over time, stakeholders can better forecast future income and the viability of investing in a business or a stock.
