What Is Deferred Revenue: Accounting Principles and Tax Treatment

Terms like “deferred revenue” can confuse non-accountants, but the concept is easy enough. Deferred revenue means that when customers pay upfront for products or services, they will receive later, your accountant recognizes that income over time rather than all at once.
In this article, we’ll explain the GAAP-compliant method of reporting, provide bookkeeping examples, and explain how the practice will impact your taxes.

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Deferred Revenue Accounting Principles

Since deferred revenue is an aspect of accrual accounting, let’s begin by distinguishing between the two primary accounting methods. Our cash vs. accrual accounting article covers the topic in-depth, but here’s a quick refresher.

The difference between these two approaches comes down to timing. With cash accounting, revenue and expenses are recognized when money enters or exits your bank account. Accrual accounting, on the other hand, recognizes revenue and expenses when committed to, regardless of when money changes hands. 

When deferred revenue is recorded, it represents a financial liability on the balance sheet to represent the cost of a service yet to be delivered.

Why Use Deferred Revenue Reporting Over Cash Accounting? 

Cash accounting is certainly simpler, so why would businesses add complexity?

There are a few reasons: 

1. It aligns with GAAP, which publicly traded companies must adhere to.
   
2. Under GAAP, it is considered a “conservative accounting” practice. In contrast to “aggressive accounting,” where one-time revenue injections can overstate company valuations, deferred revenue ensures investors and creditors aren’t misled.
   
3. Deferring revenue means matching income with related expenses, which helps financial statements report company profitability more accurately.
   
4. While revenues can appear volatile in cash accounting, this technique smooths income fluctuations and provides a more stable, representative picture of financial performance. 
   
5. It allows companies to strategically time income to maximize tax benefits.

Deferred Revenue Tax Treatment

One of the benefits is that companies can offset their current year’s tax burden. 

When income is recognized, it becomes taxable. By utilizing deferred revenue, perhaps in conjunction with taking a net operating loss, taxes can be postponed to a later date while the income can be reinvested today. 

Remember that strategic timing allows companies to delay their tax bill, not eliminate it. 

Let’s Look at an Example

The most common reason to use deferred revenue accounting is when an organization receives money upfront for services provided over time. 

For example, consider a SaaS company that sells pre-paid subscriptions. They’ll collect the money upfront but defer reporting the revenue over the contract’s lifetime. Even though they receive the money all at once, deferred revenue is the proper way to recognize the income since ongoing costs of doing business remain throughout the subscription period. 

Other services that often make use of this strategy include: 

• Newspaper Subscriptions: A publishing company that charges annually for a daily periodical.
  
• Fitness Memberships: A gym that collects upfront fees on annual memberships.
  
• Insurance Premiums: An insurance company that collects premiums at the beginning of a policy period but is obligated to provide insurance over time. 

The Journal Entry

In accounting, “journal entries” are records of financial transactions; they’re how businesses track revenue and expenses. When using deferred revenue, your journal entries will look a bit different.

Let’s continue with our SaaS company example. In addition to providing an example journal entry, we’ve set the dates to straddle two calendar years to demonstrate how deferred revenue reporting impacts taxes.

Our hypothetical software company has signed a year-long maintenance contract for $48,000, which will be paid in full on July 1st.

Let’s walk through this example:

1. After being paid, they record $48,000 in their cash account and create a corresponding entry in their deferred revenue balance.
   
2. Each month, the company debits (decreases) this account and credits (increases) the revenue record by $4,000 (one-twelfth of the original payment).
   
3. The cash account doesn’t change after the initial payment.
   
4. After twelve months, the revenue balance fully reflects the $48,000 payment, while deferred revenue has been reduced to zero.
   
5. Since the revenue is recognized over two tax years, despite receiving an upfront payment, the company will report taxable revenue to the IRS over these two years. 

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Conclusion 

Deferred revenue, a component of accrual accounting, aligns with GAAP principles, providing a conservative and transparent approach to financial reporting. Unlike cash accounting, deferred revenue recognizes income in line with service delivery rather than when cash payments are received. 

The practice promotes transparency for investors, more accurately matches income with associated costs, and carries important implications for the timing of tax burdens. 

For help with GAAP-compliant accrual accounting, indinero’s accounting services are here to help.