Deferred revenue (also known as deferred income or unearned revenue) is an important accounting concept. It is important because IFRS accounting standards state that revenue should be recorded in the P&L over the period to which it relates.
Typically, the amount of revenue recognised over a period of time will not exactly correlate to the timing of invoices raised to customers.
Where this occurs, the company will either recognise a contract asset (accrued income) or a contract liability (deferred income) for the difference between cumulative revenue recognised and cumulative invoice billings for that particular contract.
Why is deferred income a contract liability?
Think about a contract where you are billing in advance for a period of one year. At the point in time you raise that invoice, you are asking someone to pay the balance for a 12 month period. At the same time, you have an obligation to provide the services agreed as part of that invoice. The deferred income balance will therefore unwind over the period to which the service relates.
Let’s take a look at a worked example with reference to the accounting double entries.
Deferred revenue double entry example
Business raises an invoice for £120,000 for a 1 year software license:
- Cr Deferred revenue £120,000 (deferred revenue balance is created on invoice)
- Dr Trade debtors £120,000 (you are yet to receive the cash, but this is still an asset as the money is owed)
When cash is received:
- Dr Cash £120,000 (you now have the cash in your bank account – this is an asset)
- Cr Trade debtors £120,000 (as you now have the cash, this removes the trade debtor asset)
As time passes, the deferred revenue will gradually unwind with revenue being recognised in the profit and loss. For example, after 1 month, the posting would be (120,000/12 = 10,000):
- Dr Deferred revenue £10,000
- Cr Revenue £10,000
At this point, you have recognised £10,000 revenue in the P&L, and your remaining deferred income liability has reduced to £110,000 (as there is less time remaining on the license).
Deferred revenue unwind
Deferred Revenue M&A considerations
How deferred income is treated as part of deal negotiations is often a contentious topic.
The buyer will argue that deferred revenue should be treated as a net debt adjustment, whilst the seller would prefer for it to remain in working capital.
How deferred revenue is ultimately treated will likely depend on its nature. You will need to consider whether or not that deferred income is normal for the business (i.e. will it consistently replenish?) or whether it is a result of one-off factors.
You also need to consider the period over which it is expected to unwind. If a particular contract is expected to unwind over 3 years, whereas the normal advance billing is one year, the due diligence providers may argue that the deferred income balance that would remain in 12 months’ time based on the current unwind profile should be treated as net debt.