Deferred revenue has many benefits as well as risks that come with it. Understanding deferred revenue, as well as its pros and cons, can help you better apply it in your business. Using that knowledge, you can also be more cautious and safeguard yourself against the liabilities and risks that you might face.
We should start with what deferred revenue is before we discuss its pros and cons.
What is Deferred Revenue?
Deferred revenue, also known as unearned revenue, is a term used to describe the money received for a service or product that will be delivered in the future. This means that the seller or company has been paid in advance by the customer.
Deference revenue earns its name of unearned revenue since there is a lag between the purchase by the customer and its delivery.
Difference between Deferred Revenue and Recognized Revenue
There is a significant difference between deferred revenue and recognized revenue. This distinction is crucial for any business owner to understand. Knowing the difference between them can help you avoid making many common mistakes.
As mentioned before, deferred revenue is acquired for a service or product yet to be delivered in the future. This means that it has not been earned yet. In other words, it should not be counted as revenue even though you have it. But once the service or product has been delivered, that deferred revenue turns into recognized revenue since the company has earned it. Therefore, it doesn’t remain a liability anymore.
Examples of Deferred Revenue
You can better understand what deferred revenue is from examples in your everyday life. Deferred revenue is very common in many services you likely use every day, and when you look at them, you will find that this system is quite normal.
Given below are some of the more common examples that you have likely experienced.
1. Pre-Ordering Online
Have you ever done shopping online and pre-ordered a product by paying in advance using your credit card? This is the best practical example of deferred revenue. Online shopping services usually allow you to pay for the product before the retailer has released it by letting you pre-order it.
Whenever you go shopping online and pre-order a product or service, you are purchasing something that will be released and delivered to you in the future.
2. Subscription Companies
Subscription businesses are another excellent example of deferred revenue. These companies ask you to pay for using their platform and its services in advance.
Most subscription companies depend on deferred revenue. They ask you to pay for their service months, even years in advance. You can then enjoy the services from their platform until the subscription ends.
3. Gift Cards
You can buy a gift card for your favorite service and then choose to use it anytime in the future before it expires. Again, you are paying for a service in advance by buying a gift card in this example.
4. Booking a Flight
Booking a flight is one of the most common examples of deferred revenue. You cannot ask the airline to let you board a plane and then pay them afterward. You always have to pay for the flight beforehand when booking it.
All of these examples show how normal the use of deferred revenue is in our everyday life, from major to minor businesses. In all of these scenarios, you are paying for a service to be delivered in the future.
Is Deferred Revenue a Liability?
Deferred revenue is usually considered a liability by a business. This is because the company has promised to deliver a service or product and has been paid for it. This makes the company liable in case there are any problems with the delivery.
The business might be unable to deliver the service due to unforeseen circumstances, or the product might not be of the usual high quality. The customer may also cancel the order, forcing the company to pay back the deferred revenue to the customer. In all of these circumstances, the company is liable.
For these reasons, many companies do not consider deferred revenue as real revenue until it has been earned by providing the promised service.
The Pros of Deferred Revenue
So why do so many companies use deferred revenue? This is because it has certain advantages that make it quite useful and efficient.
Given below are some of the advantages of deferred revenue:
Getting Paid in Advance Protects Against Bad Debt
Companies and organizations can avoid bad debt through deferred revenue. There is no uncertainty whether the customer can or will pay for the services. This is because the payment has been provided in advance. Also, the business does not have to rely on the promise of payment.
Shows up as Sales in the Future
Deferred revenue cannot be counted as revenue until it turns to recognized revenue. But the advanced payment by the customer is going to be registered as a sale in the future.
Cash Flow is improved by Deferred Revenue
Deferred revenue improves the cash flow in a company since customers are paying for services in advance. This increase in cash flow allows a company to grow and expand.
Facilitates the Work That the Customer Has Paid for
In some cases, deferred revenue can facilitate the delivery of a product or a service. For instance, the business might need to buy some material to provide a service. Now, if the business cannot easily afford the said material, it can be pretty hard to do the job for the customer.
With deferred revenue, the customer has already paid for the service. This money can then be used to buy the required material, facilitating the delivery of the promised service.
The Cons of Deferred Revenue
Deferred revenue also has its disadvantages alongside its advantages. Knowing them both can help you avoid taking losses or making a mistake.
Given below are some cons of deferred revenue:
Deferred Revenue Can Affect the Financial Status of a Company
Many companies factor both deferred revenue and real revenue together. Doing so can have negative consequences since deferred revenue is a liability. As mentioned before, customers might demand a refund, or other unforeseen circumstances might render the delivery of promised services impossible.
Clumping deferred revenue and real revenue together can create a false illusion of profitability and growth. This can make an incorrect impression of the company’s financial status in the minds of the investors and management. This, in turn, can mean disaster for the company.
Company Has an Obligation to the Customer
When a company accepts the payment for a service in advance, it becomes obligated to the customer. Therefore, the company has to provide the promised service or product no matter what.
If it fails to do so or the quality is not up to the standards, the company has to refund the customer and possibly lose trust. This obligation to the customer can create complications.
The Company May Not be Able to keep up with Demand
The deferred revenue line may grow faster than the growth of the company itself. A business might get too many orders that have already been paid for.
If the business cannot keep up with the demand, its customers will be unhappy. This can cause a loss of revenue.
Deferred revenue has many advantages and disadvantages. Proper business planning and educating yourself can help you protect your business against the risks it presents.
In the end, deferred revenue is neither good nor bad. Depending on your circumstances, it can be beneficial for you, but it can also have negative consequences if mishandled or mismanaged.