In accrual accounting, deferred revenue, or unearned revenue, represents a liability on the balance sheet recorded on funds that a firm receives for products it has not yet provided. U.S. generally accepted accounting principles (GAAP) require certain conditions to be met before a company can recognize a revenue. If any of these conditions are not met and the company received cash payments from its customers, the company records deferred revenue by crediting the liability and debiting cash. Once the conditions are met for recognizing the revenue, the company debits the deferred revenue and credits the revenue.
Deferred revenue originates from the accounting notion of revenue recognition, which says that the revenue is recognized only when the earnings process is complete. The Securities and Exchange Commission (SEC) issued revenue recognition guidance providing four basic conditions that allow a company to recognize the revenue: If persuasive evidence of arrangement exists, delivery of goods or services occurred, the price is fixed or determinable and collectability of funds is reasonably assured, the company is allowed to recognize the revenue. Otherwise, the company must record deferred revenue for any funds received from its customers.
Consider a country club that collects dues from its customers. The annual fee is $240, which is charged immediately when a member signs up to join the club. At the time of cash receipt, the services are yet to be provided and the golf club debits cash and credits deferred revenue for $240. After the first month into membership, the golf club recognizes $20 in revenue by debiting the deferred revenue account and crediting the sales account. The golf club continues recognizing revenue each month until the end of the year, when the deferred revenue account is zero and $240 shows up on the club’s annual income statement.
The country club example is one of the simplest instances of recognizing the revenue and recording deferred revenue, since the timing of delivering services or goods is easy to determine. In certain instances, the timing is very difficult to determine; GAAP allows different methods of revenue recognition that can depend on circumstances and the type of industry in question. Depending on the method chosen, the company’s financial statements may look drastically different, with different amounts of deferred revenue recorded, even though the economic reality remains unchanged.
Consider a contractor that can use either the percentage-of-completion method or the completed contract method to recognize revenue. Under the percentage-of-completion method, the company recognizes revenue as certain milestones are met. Under the completed contract method, the company does not recognize any profit until the entire contract and its terms are fulfilled. In this case, the completed contract method results in lower revenues and higher deferred revenue than the percentage-of-completion method.