What’s Deferred Revenue?
If you're following Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) for accrual accounting, you're calculating and recording deferred revenue. When you record the sale, you are entering into a contract with that customer to deliver goods or services in the future. This is a deferred revenue liability. Contrary to what the name implies, Deferred Revenue is not actual revenue yet.
How to Record Deferred Revenue
When a customer initiates their order, a liability of Deferred Revenue is created and an asset of Accounts Receivable is also recorded to reflect the expectation of future cash to be received. Because the company has not fulfilled its obligation of merchandise, an exercise machine, or their first box in an annual subscription the company has not earned any revenue just yet.
In the US, ASC 606 requires GAAP-compliant companies to record revenue while adhering to the matching principle and following the 5-step process outlined by the FASB in the guidance. Revenue can be recognized when each of the steps below have been completed:
1. Identify the contract or contracts with the customer.
2. Identify the contract's specific performance obligations.
3. Determine the transaction price.
4. Allocate the transaction price to performance obligations.
5. Recognize revenue when you've fulfilled each performance obligation.
Why Tracking and Recording Deferred Revenue is Important
Recognizing revenue in the period that it was earned versus at the time of sale can have a meaningful impact on the amount shown on the income statement.
- In businesses where there’s a delay between the order and the time of fulfillment or that sell products or services that are fulfilled over long periods of time (i.e. annual subscriptions), the difference can be significant.
- We’ve also seen discrepancies with businesses that have a high cancellation rate. In this instance, if they’ve recognized the revenue upon sale and not upon fulfillment, they’ve overstated their revenue and then need to adjust out those orders that were canceled and never fulfilled.
Deferred revenue does represent a liability in that the business has yet to deliver the product or service. For practical purposes by not recording deferred revenue, there could be an obligation with real costs that need to be incurred in the future. For companies that ship physical goods, the future cost could include the actual cost of the product to the business along with shipping and fulfillment costs to deliver it.
On a related note, the matching principle in accounting says that you need to match expenses in the same period that the corresponding revenue was earned. From a practical perspective when you look at an income statement you can easily see the revenue that was truly earned in the period and the corresponding costs with that sale. By not recognizing revenue based on delivery and matching costs, it is difficult to understand the true cost of providing that good or service. Without a true understanding of revenue and cost of goods sold — or gross margin, a business may be missing critical opportunities to improve its profitability.
How Does Blue Onion Help?
Blue Onion can make Deferred Revenue easier to track and calculate. Not sure where to start? Book a free consultation with our Accounting Expert team to see how Blue Onion helps leading brands reduce manual data processing and calculations in their workflow.
