When you purchase a can of soda from a vending machine, there is very little delay between the delivery of goods and payment for services. For multi-year contracts or retainers, however, the gap between delivery and payment can be quite large, creating a challenge when recording the related income on a company balance sheet.
Typically, there are two methods used to account for this gap: accrued revenue and deferred revenue. The method you chose informs how you might answer questions like the following:
When should you record that a transaction has been made?
When should the associated revenue show up on your balance sheet?
What do you do when the payment for a transaction doesn’t happen at the same time as the exchange of goods or services?
At its most basic level, the biggest difference between accrued revenue vs. deferred revenue is a matter of timing. But there’s quite a bit of nuance when comparing the two payment methods. We take a deeper look at understanding accrued vs. deferred revenue and what those differences might mean for a business.
Understanding the importance of revenue standards
Choosing the right accounting strategy for your business and accurately recording these transactions is critical to your company’s financial health. In fact, various accounting practices and standards have been developed over time just to keep these records consistent across organizations.
One of the most prominent of these standards is the collection of generally accepted accounting practices (GAAP) outlined by the Financial Accounting Standards Board (FASB). And the U.S. Security and Exchange Commission requires that any publicly-traded company in the U.S. needs to comply with these GAAP guidelines.
Of course, for smaller, privately-owned businesses, there are no current regulations to meet these GAAP standards. While GAAP practices are a requirement for any publicly traded company, they’re considered best practices for private companies as well. Employing consistent, industry-accepted best practices for your bookkeeping efforts can deliver clearer insight into your company and help avoid a number of headaches.
What is accrued revenue?
Put simply, accrued revenue reflects the amount of income that has been earned by providing a good or service but for which the payment has not yet been received—particularly if the payment isn’t expected in the current accounting window.
Consider any credit card purchases made on the last day of the month. While the buyer already possesses their merchandise, the seller typically won’t have the payment fully processed and finalized until a few days into the next month. Accrued revenue reflects that income within the seller’s bookkeeping even though the cash hasn’t hit their account yet.
Common among service-based businesses, accrued revenue is a key component of accrual accounting, where these unrealized payments are regularly tracked as accounts receivable on the company balance sheet. The exchange is also identified as an adjusting journal entry that records items that would otherwise not appear in the general ledger at the end of an accounting period.
Conversely, were this income only recorded when the funds had been received, the organization’s revenue and profit would be reported in a less consistent manner, making it much more difficult to properly assess the overall health and financial standing of the business. For this same reason, when employing an accrual accounting method, many businesses will also rely on bank reconciliation statements to further account for and monitor these payment gaps.
Tracking accrued revenue is also necessary to comply with GAAP standards, particularly the revenue recognition principle and the matching principle. Revenue recognition requires that revenue transactions are recorded in the same accounting period that they are earned. While the matching principle drives businesses to tie any revenue generated in an accounting period with the corresponding expenses related to that work.
An accrued revenue example:
John A. Crude is the CEO of a publicly-traded construction company. And his business just closed a $2 million deal for a row of townhomes. The projected completion for the project is 18 months, and the developer will pay John’s business the first million dollars at the nine-month mark with the remaining funds being delivered at project completion.
For much of this work, John’s business will need to outlay the initial expenses of the project before receiving any actual funds from its customer. But to comply with GAAP standards—particularly the matching principle—the construction company will need to document some of this revenue each month to align with the ongoing expenditures for such a large, long-term project.
What is deferred revenue?
Deferred revenue—sometimes referred to as “unearned revenue”—is an accounting entry for recording income and other payments when they are received before the corresponding work has been completed or the product delivered. These types of transactions are only growing more prevalent with the rise of advance billing—a billing strategy that invoices customers before work is finalized, ideally increasing the possibility that an account will be paid on time.
Consider any purchase that you might pay for up-front—an online order, prepaid rent for an apartment, or an annual streaming service subscription. If these organizations record your payment on their balance sheet at the time of the transaction while the actual delivery of your good or service won’t occur until the next accounting period, this outstanding obligation is noted as deferred revenue according to GAAP guidelines, particularly those relating to accounting conservatism.
Specifically, this unearned income isn’t actually tracked on a company’s income statement as it doesn’t affect its net income or loss. Instead, it is recorded on the balance sheet as a liability since the buyer might cancel the order for the product or service, or the seller might run into difficulties—such as a material shortage—that prevent delivery. In either case, the seller would need to refund either all or part of the purchase unless a signed contract states otherwise.
For this reason, unearned revenue is only shifted to the income statement after the delivery obligation has been fully met. Alongside these deferred revenue liability entries, a corresponding journal entry increases the cash level.
Altogether, this accounting method makes it easier for a business to communicate its financial health to its stakeholders or potential new investors since it can display the organization’s limited amount of outstanding liabilities.
A deferred revenue example:
Bob D. Ferd is the founder of a boutique software company that offers one product—a cloud-based patient check-in system. Ferd’s company sells licenses for this software to medical offices on a yearly basis, meaning that all of the organization’s customers pay the full cost up-front. The software provider is then obligated to provide access to the check-in system for the next 12 months.
The company initially tracks these up-front licensing payments as liabilities on its balance sheet. But to comply with GAAP standards—again the matching principle in particular—each month the firm will shift a 1/12 portion of the annual payment onto its income statement. And by the end of the 12-month agreement, the liability will have been fully removed from the organization’s bookkeeping.
Key differences between accrued and deferred revenue
Properly understanding both accrued and deferred revenue is critical to properly understanding your business. To assume that all of your documented revenue is liquid can lead to unexpected shortages or financial pressure. While failing to effectively track your liabilities can similarly disrupt planning efforts.
To simplify the contrast between these two revenue-tracking strategies, consider the chart below:
|Payment||Occurs after work/delivery has been completed||Occurs before work/delivery has been completed|
|Balance Sheet||Initially tracked as accounts receivable||Initially tracked as a liability|
|Resolution||When the payment is completed||When all associated work is completed|
|Processing||Shifts from earned revenue to an adjusted entry on the asset account||Shifts from liability to revenue on the income statement|
|Insight||Offered into total revenue earned||Offered into working capital|
|Common Industries||Service, Construction||Insurance|
Accrued Expense vs. Deferred Expense
While exploring the concepts of accrued and deferred revenues, it’s wise to also consider the inverse of these tracking methods, accrued and deferred expenses.
Much like accrued revenue, an accrued expense reflects a transaction where the actual payment is made after the good or service has been fully provided. However, an accrued expense instead documents the outstanding liability of the buyer.
Consider a standard power or water payment. These are typically rated on a consumption basis, so the invoice for the utility can’t be issued until after the service period, often requiring payment at least a full month later. So in the interim period, the invoiced amount would be debited as an expense on the company balance sheet and also credited to accounts payable. And when the bill is actually paid, the transaction would be recorded as a debit to accounts payable and a credit to cash.
Similarly, a deferred expense matches deferred revenue, tracking transactions that are paid in advance of project completion or delivery. But a deferred expense is actually recorded by the buyer initially as an asset that is then debited as an expense throughout each accounting period depending on the delivery timeline.
For a common example, most insurance premiums serve as deferred expenses since the customer routinely pays at the start of the coverage period.
Invoiced: Automated A/R revenue insights at your fingertips
When actually tracking both accrued and deferred revenues, many businesses don’t recognize these adjustments in real-time. Instead, they commonly ignore any accrued revenue while tracking deferred revenue the same as any other payment. At the end of the accounting period, however, the relevant accounting department will create adjusted journal entries as part of the closing process.
As accrued revenues are identified during the closing period, they are entered into the system. Meanwhile, revenue accounts are reviewed to verify that there aren’t any unearned deposits that need to be recategorized as a liability. Commonly, this shift is tracked via a journal entry that debits regular revenue and credits the liability account.
No matter the strategy, accurately capturing both accrued and deferred revenues can at times be complicated—particularly when dealing with any delinquent payments. That’s why many organizations rely on automated A/R collection platforms to streamline the tracking and reporting of these unrealized payments.
Invoiced’s AI-powered cash application engine can help eliminate guesswork and automatically link unapplied payments and invoices. At the same time, our platform allows you to gain greater visibility into the cash flow and overall financial standing of your business—for today and tomorrow—with comprehensive payment analytics and collections forecasting.
Wish to mitigate the stress of matching which payments go with which invoices and balances? Schedule a demo of our Payment Acceptance platform today!