Deferred revenue explained: Why getting paid isn’t the same as earning revenue

Imagine you’re running a SaaS company that offers project management software, and you just closed a deal with a customer who prepaid $12,000 for an annual subscription. The payment entered your bank account today. Despite that, you can’t count it as revenue yet because you haven’t fulfilled all twelve months’ worth of deliverables. Instead, the revenue must be recognized monthly as you fulfill your promised services to the customer.

This accounting rule is known as deferred revenue. The key takeaway here is that incoming cash and deferred revenue move on different timelines. Counting cash as earned income is a common mistake made by first-time operators, but one that you can avoid with the right knowledge. 

In this article, we’re walking through what “deferred revenue” means, whether it’s an asset or a liability, how it affects financial statements, and when revenue can actually be recognized.

For background, cash basis accounting is an accounting method in which revenue is recognized when cash is deposited into your bank account. In contrast, in accrual accounting, revenue is recognized when it’s earned. Venture-backed startups typically use the accrual basis of accounting for financial reporting. 

Deferred revenue is a core principle of accrual accounting. Businesses that use this accounting method will record revenue when it's earned — not when cash is received. 

Think of it this way: Startups using accrual accounting must recognize revenue once they’ve actually delivered their goods or services to customers. For instance, if your client prepays a $48,000 one-year subscription, your company earns $4,000 in revenue ($48,000 divided by 12 months) each month for the duration of the subscription. 

Some other common examples of deferred revenue include:

• Annual SaaS subscriptions
• Cloud-hosting subscriptions
• Conference or event ticket sales
• Gift cards 
• Multi-year enterprise agreements
• Membership-based platforms
• Online courses 
• Preorders of products 
• Prepaid listing packages or service contracts
• Rental or leasing agreements
• Retainer agreements
• Streaming services
• Subscription boxes 

In short: Deferred revenue is classified as a liability. 

Even after a company receives payment from a customer, the company, of course, still has an obligation to deliver goods or services. In accrual accounting, this promise to fulfill future deliverables is recognized as a liability. 

On the balance sheet, deferred revenue is recorded as a liability until the goods or services are delivered. Liabilities can be categorized into two types: current or non-current. If a business plans to fulfill its obligations within the next 12 months, the deferred revenue is classified as a current liability. Otherwise, it’s labeled as a non-current liability (or a long-term liability) if the company anticipates that it’ll take more than a year to complete its obligations, such as under a multi-year contract. 

Potential lenders keep an eye on liabilities because they’re key indicators of a company’s obligations and forecasted performance. 

In this sample scenario, a streaming service company signs a $12,000 annual contract with a client who pays upfront. When following the accrual accounting method, businesses recognize revenue when it’s earned over time. So, this company would simply recognize $1,000 per month ($12,000 divided by 12 months) for the duration of the contract.

Early-stage founders may wonder about the difference between unearned revenue vs. deferred revenue. Generally, in most cases, these terms are used interchangeably, since both describe cash received for goods or services that haven’t been delivered or completed yet.

However, there’s a slight distinction between the two: 

• Unearned revenue is the cash a company receives before delivering goods or services.
• Deferred revenue is listed as a liability on the balance sheet until the cash is recognized as revenue.

Ultimately, both terms refer to payments received before a customer's deliverables are completed.

Let’s review two more terms: accrued revenue vs. deferred revenue. 

Here’s a simple explanation of the difference between these accounting concepts::

• Accrued revenue is revenue that you earned but have yet to receive payment for. You provided value to the customer first, but cash will come later. (For example, if a graphic design company completed a project in May, but the client didn’t pay until June, the company would still recognize the revenue in May.) 
• Deferred revenue is the cash payment you received but have yet to earn. You collected the cash first, but you’ll provide value to the customer afterward. Essentially, it’s the opposite scenario of accrued revenue. 

A comparison of accrued revenue and deferred revenue

Tax treatment can vary depending on the accounting method you use. Businesses using accrual accounting methods treat deferred revenue as a liability and only recognize the revenue when their obligations are complete. But the IRS generally requires companies to record upfront payments at the time of receipt and to report their deferred revenue as taxable income when cash is received. 

This timing difference between fulfilling your deliverables and receiving payments can create a mismatch between your financial books and your tax return. It’s a good idea to seek advice from a tax expert, such as a certified professional accountant (CPA), when you’re dealing with deferred revenue tax treatment. 

Deferred revenue can affect both your balance sheet and income statement. Tracking deferred revenue is essential for understanding your startup’s current financial position, getting insights into your cash flow, and forecasting future growth. It can serve as a key positive indicator, particularly for businesses in the SaaS industry. 

By matching revenue to the timeframe when the final products and services are delivered to the customer, deferred revenue provides a precise overview of your company’s performance. Finance leaders and chief financial officers (CFOs) that use accrual accounting can rely on their financial statements to demonstrate their company’s true financial health and, in turn, build trust with key stakeholders.

Understanding how deferred revenue impacts your startup’s overall financial picture can help support your fundraising efforts, too. Investors like to monitor financial metrics to evaluate a startup's valuation and future revenue potential, so having clear and accurate data can help instill confidence in your investors and board of directors.