Deferred revenue
Paid now, earned later: the liability that turns into revenue as the work is delivered.
- Record an upfront payment on all three statements
- Calculate revenue recognized and deferred revenue remaining after any number of months
- Explain why cash runs ahead of net income
- Work out how far into a contract a company is from its balance sheet
The intuition
You pay a gym $1,200 in January for a full year of membership. The gym has your cash, but it has not earned it yet: it still owes you eleven more months of workouts. If the gym closed in February, you would want most of your money back.
So the gym records the $1,200 as deferred revenue, a liability for service it still owes. Each month it delivers, $100 moves out of the liability and into revenue.
Revenue follows delivery, not cash. An upfront payment raises cash and a liability on day one; revenue and net income arrive month by month as the liability unwinds.
Why it works
- Day one. Cash rises by the payment, P. Deferred revenue, a liability, rises by the same P. Nothing has been delivered, so revenue and net income do not move. Assets and liabilities rose together: it balances.
- Each month. P ÷ N of revenue is recognized and the liability falls by the same amount. No new cash arrives.
- Tax. Revenue is taxed as it is recognized (these questions ignore the cost of delivering the service). Net income is recognized revenue × (1 − t), and the tax paid is the only cash that moves after day one.
- Why cash runs ahead. Cash from operations includes the increase in deferred revenue, so it stays above net income while the company holds money it has not yet earned.
| Revenue per month: 120 ÷ 12 | 10.0 |
| Revenue recognized so far: 10 × 3 | 30.0 |
| Deferred revenue still owed: 120 − 30 | 90.0 |
| Net income so far: 30 × (1 − 25%) | 22.5 |
| Cash: 120 received − 7.5 tax paid | 112.5 |
| = Check: cash 112.5 = liability 90.0 + equity 22.5 | balances |
The formulas
Cash in, service owed, nothing earned yet.
The contract spread evenly over its months.
What has been earned so far.
What is still owed.
Earned revenue after tax, ignoring delivery costs.
The upfront payment, less tax paid on what has been earned.
Worked example
Spread the contract evenly, then count the months delivered.
See it move
Same company. Move through the contract month by month, or change the payment and the tax rate.
- Drag the months forward. Revenue rises and deferred revenue falls by exactly the same amount.
- Go to the last month before the contract ends. Almost all of the payment has now become revenue.
- Raise the tax rate. Net income and cash both fall by the extra tax, and deferred revenue does not move at all.
- The balance check stays green: cash always equals what is still owed plus what has been earned after tax.
Run it backwards
Same company, reversed: all you see is the deferred revenue left on the balance sheet. How far into the contract is it?
What has been earned is the payment less what is still owed. Divide that by one month of revenue, P ÷ N, and you have the months delivered.
Investors in subscription businesses read deferred revenue exactly this way: it is revenue already paid for, waiting to be recognized.
Traps
Say it in the interview
“A customer pays $120 upfront for a year of service. Walk me through the statements on day one and after three months, at a 25% tax rate.”
Check yourself
4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.
Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.
- Upfront cash: cash +P, deferred revenue +P, revenue 0.
- Each month, P ÷ N moves from the liability into revenue.
- Cash runs ahead of net income while revenue is deferred.
- Deferred revenue is service owed, not debt.