Last editedMar 20222 min read
Deferred revenue is common for online and subscription-based businesses. So, what is deferred revenue, and how does it relate to your cash flow statement? We’ll cover how to treat deferred income in the guide below so that you can better manage your everyday cash flow.
What is the cash flow statement?
A cash flow statement records all business activities that lead to an inflow or outflow of cash during a specific accounting period. It’s broken up into three sections:
Operating cash flow describes all activities linked to everyday business operations.
Investing cash flow describes all activities related to purchasing equipment, machinery, or shares.
Financing cash flow describes cash flow activities related to capital, including dividend payments and debt repayments.
What is deferred revenue?
Also called unearned revenue, deferred revenue describes payment received before a product has been delivered or service provided. Because the company hasn’t yet completed the transaction with delivery of product or service, it’s considered unearned. Sometimes deferred revenue takes the form of a physical prepayment, but it can also be an agreement for payment, or accounts receivable.
Those wondering how to treat deferred income in accounting can look to the accrual method. According to accrual accounting, revenue should only be recognised when it’s earned. Because deferred revenue has not yet been earned, it’s recorded as a liability on the balance sheet rather than as profit on the income statement.
Can you record deferred revenue before receiving cash?
Yes, you can still record deferred revenue as a liability on the balance sheet even if you haven’t yet received the cash. However, this does impact the cash flow statement because there is no cash inflow to record. Cash inflows are recorded under the operating section of the cash flow statement only when cash is received.
It’s common in the insurance, utilities, and real estate industries for customers to make upfront payments before receiving their services. The accountants in these industries will record the unearned revenue on the balance sheet – but they will only mark it on the cash flow statement when cash exchanges hands. When services are provided and cash received, the revenue is finally recognised on the income statement.
How does deferred revenue affect cash flow?
A high level of deferred revenue can have a significant impact on cash flow. Whether you’re providing subscription boxes or selling digital software, your business could end up with a large cash inflow before services are delivered. This means you could have a high cash inflow without income, and vice versa.
To help account for this and keep your books balanced, you can use the double entry accounting method. Imagine that you have received a £50 payment from a customer for an ecommerce order that has not yet been delivered.
A debit of £50 to Cash to show the payment received
A credit of £50 to Deferred income to show the current liability owed to the customer
No entry is made in the sale account, because the revenue will not be earned or recognised until the transaction is final. After you’ve delivered the order to the customer, you can balance the books with the following double entry:
A debit of £50 to Deferred income to remove the current liability on the balance sheet
A credit of £50 to Sales to reflect the earned income or revenue
Deferred revenue tax treatment would also reflect both the generally accepted accounting principles (GAAP) along with basic standards of accrual accounting like revenue recognition and the matching principle.
How to treat deferred income when managing cash flow
The example above shows how to treat deferred income in your general ledger, but what about its impact on cash flow? When you receive large volumes of cash up front, it’s tempting to reinvest the money back into your business or pay off bills. However, it’s best to wait until you’ve completed the sale and recorded the entry as revenue before treating this money as income. Your cash inflows will increase but so will your current liabilities. In other words, the cash isn’t liquid. It’s important to keep all of this in mind when assessing cash flow.
We can help
GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments.