What is deferred income?

Deferred income is a term used in accounting to describe money a business has received for goods or services that haven't been delivered yet. It's essentially a liability, not income, until the product or service is provided. 

Essentially, you can think of deferred income as a promise from a business to deliver something in the future in exchange for upfront payment. 

Aside from this simple definition, there are many more aspects to deferred income that are important to know for any business that offers or is paying for services. Here, we'll explore how deferred income works, why it's considered a liability, and how it may impact a company’s financial health.

How does deferred income work?

When a company receives a payment for goods or services that they have not yet received, they will count this payment as deferred income. This advance payment is not immediately recognised as revenue, as the company still has to provide the goods or services in question. 

So, on the company’s balance sheet, deferred income would be a liability, as they have a responsibility to either deliver the promised goods, or refund the payment if this is not honoured. That is, unless there are other payment terms that are explicitly stated in the contract. 

According to the Financial Reporting Standards (FRS) followed in the UK, revenue should be recognised when (or as) the business satisfies a performance obligation. This means that revenue is recorded when the goods are delivered or services are provided, and the payment is reasonably assured.

This approach aligns with the principle that revenue and related expenses should be recorded in the same period. Businesses may deviate from this principle if they prematurely recognise deferred income as earned revenue or if they post such payments directly into their income statement without proper matching.

In short, this means that they have overstated their sales revenue, and have inaccurately recorded their finances. 

Deferred revenue can either be classified as a current liability or a long-term liability, should the obligation go beyond 12 months. 

Accrued income vs. deferred income: what’s the difference?

Accrued income and deferred income are essentially opposite accounting concepts when it comes to the categorisation of incoming funds. 

Accrued revenue occurs when a company has delivered goods or provided services but has not yet issued an invoice or received payment. Since the income has been earned, it is recognised as revenue on the income statement and recorded as a current asset under accrued income on the balance sheet. 

Deferred revenue, as we have touched on, refers to when a company receives payment in advance for goods or services that have not yet been delivered. Since the income has not yet been earned, it is recorded as a liability on the balance sheet under deferred income. 

Unlike accrued income, here the revenue is only recognised on the income statement once the goods are delivered or the services are provided.

Examples of deferred revenue for small businesses

There are many different situations where deferred revenue may play a role in business transactions. 

Two common examples of deferred revenues for small businesses may include gym memberships and software subscriptions. 

In the case of gym memberships, the following scenario may occur:

• Upfront payment: When a customer pays for a year's membership in January, the gym records the entire amount as deferred revenue.

• Monthly recognition: Each month, a portion of the deferred revenue is categorised as earned income. For example, if the annual membership is £1200, the gym would recognise £100 as revenue each month.

• Accounting for cancellations: If a member cancels their membership mid-year, the gym needs to adjust the deferred revenue account to reflect the remaining unused portion.

Whereas, in the case of Software-as-a-Service (SaaS) businesses, where customers pay upfront for access to the software, deferred revenue may include:

• Subscription tiers: Different subscription plans (monthly, annual, etc.) create varying deferred revenue amounts.

• Renewal cycles: The business must track subscription renewal dates to accurately recognise revenue.

• Churn rate: Customer churn can impact deferred revenue as it reduces the expected revenue from subscriptions.

How to manage deferred income

Now you know what deferred income is, how it works and where you might find it in a business setting, it’s time to learn how to manage it in a practical sense. You’ll need to know who to record deferred revenue, and what to watch out for on your income and balance sheets. 

How is deferred revenue recorded in bookkeeping?

Properly accounting for deferred income involves several key steps. First, when the payment is received, it is recorded as cash, but an equal amount is also recorded as a liability under deferred income. 

As the company delivers the goods or services over time, the corresponding portion of deferred income is gradually recognized as revenue on the income statement. This process ensures that revenue is matched with the period in which the goods or services are actually delivered.

This approach provides a more accurate depiction of the company's financial health and prevents the overstatement of revenue.

Can you have deferred revenue in accrual accounting?

While accrual accounting primarily deals with categorising revenue when it is earned, deferred revenue does fit within the accrual accounting framework.

In accrual accounting, all financial events are recorded when they occur, regardless of when cash transactions happen. This means that both accrued revenue and deferred revenue are part of accrual accounting.

Is deferred income an accounting liability?

If you’re a business owner, it may be tempting to treat an advance payment for future services as immediate revenue. However, deferred revenue should be recorded as a liability on the balance sheet. 

This is because the company has an obligation to either deliver the promised goods or services or refund the payment if they’re unable to fulfil the contract. Therefore, deferred income is not considered earned revenue until the goods or services have been provided.

Final thoughts

As we’ve seen, getting to grips with deferred income is vitally important for ensuring that your business complies with accounting principles. This will help you avoid overstating your income and maintain accurate financial statements. 

This is where Quickbooks Advanced can step in. Designed for medium-sized businesses, our Advanced SKU offers exclusive revenue recognition tools that help you easily manage deferred income.

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