What is the difference between accounts receivable and deferred revenue

Deferred Revenue vs. Accrued Expense: What’s the Difference?

Deferred Revenue vs. Accrued Expense: An Overview

Deferred revenue, also known as unearned revenue, refers to advance payments a company receives for products or services that are to be delivered or performed in the future. Accrued expenses refer to expenses that are recognized on the books before they have actually been paid.

As an example, SaaS (software-as-a-service) businesses that sell pre-paid subscriptions with services rendered over time will defer revenue over the life of the contract and use accrual accounting to demonstrate how the company is doing over the longer term. This approach helps highlight how much sales are contributing to long-term growth and profitability.

Key Takeaways

Deferred Revenue

Deferred revenue is an obligation on a company’s balance sheet that receives the advance payment because it owes the customer products or services.

Deferred revenue is most common among companies selling subscription-based products or services that require prepayments.

Examples of unearned revenue are rent payments made in advance, prepayment for newspaper subscriptions, annual prepayment for the use of software, and prepaid insurance.

In the case of a prepayment, a company’s goods or services will be delivered or performed in a future period. The prepayment is recognized as a liability on the balance sheet in the form of deferred revenue. When the good or service is delivered or performed, the deferred revenue becomes earned revenue and moves from the balance sheet to the income statement.

Accrued Expense

Under the revenue recognition principles of accrual accounting, revenue can only be recorded as earned in a period when all goods and services have been performed or delivered. If a company’s goods or services have not been performed or delivered, but a customer has paid for a future service or a future good, the revenue from that purchase can only be recorded as revenue in the period in which the good or service is performed or delivered.

Under the expense recognition principles of accrual accounting, expenses are recorded in the period in which they were incurred and not paid. If a company incurs an expense in one period but will not pay the expense until the following period, the expense is recorded as a liability on the company’s balance sheet in the form of an accrued expense. When the expense is paid, it reduces the accrued expense account on the balance sheet and also reduces the cash account on the balance sheet by the same amount. The expense is already reflected in the income statement in the period in which it was incurred.

Example

Explain the difference between deferred revenue and accounts receivable. How does revenue recognition and the matching principle impact the calculation of deferred revenue?

Deferred revenue is the portion of a company’s revenue that has not been earned, but cash has been collected from customers in the form of a prepayment.

Accounts receivable are amounts of money owed by customers to another entity for goods or services delivered or used on credit but not yet paid for by clients.\n

\nThe core principle of ASC 606 is that revenue is recognized when the delivery of promised goods and\/or services matches the amount of consideration expected in exchange for the goods and\/or services.

In this sense, revenue recognition and the matching principle can impact the calculation of deferred revenue since we don’t know if the delivery of promised goods and\/or services can meet the expectation of the firm.

Deferred revenue is the portion of a company’s revenue that has not been earned, but cash has been collected from customers in the form of prepayment. However, Accounts Receivable represents the income from products or services that have been sold and delivered. «>]» data-testid=»answer_box_list»>

Answer:

Deferred revenue is the portion of a company’s revenue that has not been earned, but cash has been collected from customers in the form of a prepayment.

Accounts receivable are amounts of money owed by customers to another entity for goods or services delivered or used on credit but not yet paid for by clients.

The core principle of ASC 606 is that revenue is recognized when the delivery of promised goods and/or services matches the amount of consideration expected in exchange for the goods and/or services.

In this sense, revenue recognition and the matching principle can impact the calculation of deferred revenue since we don’t know if the delivery of promised goods and/or services can meet the expectation of the firm.

Explanation:

Deferred revenue is the portion of a company’s revenue that has not been earned, but cash has been collected from customers in the form of prepayment. However, Accounts Receivable represents the income from products or services that have been sold and delivered.

How Is Deferred Revenue Connected to Accounts Receivable?

Related

A great irony of accounting on an accrual basis is that it lets companies report revenue that they do not have and actual cash that they have not earned. Accounts receivable and deferred revenue accounts convert to cash over time and represent how customers pay for different products and services. Companies and small businesses that use accrual accounting might be able to leverage both accounts for growth and income.

Accrual-Basis Accounting

Also called accrual accounting, accrual-basis accounting is a method for recording cash flows consistent with the transactions that generate them without regard to receipts or payments of physical cash. In other words, upon the sale of a product or service, the consequent income earned is immediately accounted for. Similarly, if a company places an order for supplies, for example, the related cost of those supplies is immediately accounted for. Accrual accounting is practiced by most companies for preparing periodic financial statements. Depending on its size, a small business may be advised to follow a cash-basis accounting method, which records receipts and payments only once money has actually moved. Small businesses should consult a qualified accountant to learn if they can benefit from accrual accounting.

Accounts Receivable

Accounts receivable represents the income from products or services that have been sold and delivered, but for which payment has not yet been received. Accounts receivable, often called AR, is a balance sheet asset that is credited when when revenue has been earned, but not yet received. As a company receives money from clients, it debits the AR balance and credits its cash balance. All companies, but small business in particular, should closely monitor accounts receivable, because high balances may indicate or result in insolvency from low cash inflow.

Deferred Revenue

Deferred revenue reflects cash receipts in connection with goods and services that have not yet been delivered or rendered. Deferred revenue is located in the liabilities section of a balance sheet. Examples of deferred revenue include proceeds from gift certificates and magazine subscriptions wherein products are delivered to the payer at a later time. Each time a company delivers a product or renders a service for which it already received payment, it recognizes the earnings by debiting its deferred revenue balance and crediting its cash balance for the appropriate amount. Small businesses that record deferred revenue should monitor their deferred revenue balance, because a high balance might indicate inefficiency delivering goods and services.

Relationship

Except that a reduction in either account results in an equal increase in the cash account, there is no causal relationship between accounts receivable and deferred revenue. Both accounts represent a company’s purveyance of goods or services on a payment-per-delivery (accounts receivable) or a prepaid (deferred revenue) basis. This means that companies with both accounts on their balance sheets generate potentially higher revenue than those that record only one or the other. Small businesses that pursue accrual accounting may wish to explore if they can expand by integrating both accounts.

Accounting Interview Questions & Answers (Advanced)

These more advanced questions cover topics like deferred tax assets and liabilities and how to actually project a company’s financial statements in an operating model.

You may get some of these in investment banking interviews, but they’re more common if you’ve had significant finance experience or you’re interviewing for private equity, or with a more technical group.

1. How is GAAP accounting different from tax accounting?

2. What are deferred tax assets/liabilities and how do they arise?

They arise because of temporary differences between what a company can deduct for cash tax purposes vs. what they can deduct for book tax purposes.

Deferred Tax Liabilities arise when you have a tax expense on the Income Statement but haven’t actually paid that tax in cold, hard cash yet; Deferred Tax Assets arise when you pay taxes in cash but haven’t expensed them on the Income Statement yet.

3. Walk me through how you create a revenue model for a company.

There are 2 ways you could do this: a bottoms-up build and a tops-down build.

Of these two methods, bottoms-up is more common and is taken more seriously because estimating «big-picture» numbers is almost impossible.

4. Walk me through how you create an expense model for a company.

To do a true bottoms-up build, you start with each different department of a company, the # of employees in each, the average salary, bonuses, and benefits, and then make assumptions on those going forward.

Usually you assume that the number of employees is tied to revenue, and then you assume growth rates for salary, bonuses, benefits, and other metrics.

Cost of Goods Sold should be tied directly to Revenue and each «unit» produced should incur an expense.

Other items such as rent, Capital Expenditures, and miscellaneous expenses are either linked to the company’s internal plans for building expansion plans (if they have them), or to Revenue for a more simple model.

Use estimates. For the revenue if you don’t have enough information to look at separate product lines or divisions of the company, you can just assume a simple growth rate into future years.

For the expenses, if you don’t have employee-level information then you can just assume that major expenses like SG&A are a percent of revenue and carry that assumption forward.

6. Walk me through the major items in Shareholders’ Equity.

Common items include:

7. Walk me through what flows into Retained Earnings.

If you’re calculating Retained Earnings for the current year, take last year’s Retained Earnings number, add this year’s Net Income, and subtract however much the company paid out in dividends.

8. Walk me through what flows into Additional Paid-in Capital (APIC).

APIC = Old APIC + Stock-Based Compensation + Stock Created by Option Exercises

If you’re calculating it, take the balance from last year, add this year’s stock-based compensation number, and then add in however much new stock was created by employees exercising options this year.

9. What is the Statement of Shareholders’ Equity and why do we use it?

You don’t use it too much, but it can be helpful for analyzing companies with unusual stock-based compensation and stock option situations.

10. What are examples of non-recurring charges we need to add back to a company’s EBIT / EBITDA when looking at its financial statements?

Note that to be an «add-back» or «non-recurring» charge for EBITDA / EBIT purposes, it needs to affect Operating Income on the Income Statement. So if you have one of these charges «below the line» then you do not add it back for the EBITDA / EBIT calculation.

11. How do you project Balance Sheet items like Accounts Receivable and Accrued Expenses in a 3-statement model?

Normally you make very simple assumptions here and assume these are percentages of revenue, operating expenses, or cost of goods sold. Examples:

Then you either carry the same percentages across in future years or assume slight changes depending on the company.

12. How should you project Depreciation & Capital Expenditures?

The simple way: project each one as a % of revenue or previous PP&E balance.

The more complex way: create a PP&E schedule that splits out different assets by their useful lives, assumes straight-line depreciation over each asset’s useful life, and then assumes capital expenditures based on what the company has invested historically.

13. How do Net Operating Losses (NOLs) affect a company’s 3 statements?

The «quick and dirty» way to do this: reduce the Taxable Income by the portion of the NOLs that you can use each year, apply the same tax rate, and then subtract that new Tax number from your old Pretax Income number (which should stay the same).

The way you should do this: create a book vs. cash tax schedule where you calculate the Taxable Income based on NOLs, and then look at what you would pay in taxes without the NOLs. Then you book the difference as an increase to the Deferred Tax Liability on the Balance Sheet.

14. What’s the difference between capital leases and operating leases?

Operating leases are used for short-term leasing of equipment and property, and do not involve ownership of anything.

Operating lease expenses show up as operating expenses on the Income Statement.

Capital leases are used for longer-term items and give the lessee ownership rights; they depreciate and incur interest payments, and are counted as debt.

A lease is a capital lease if any one of the following 4 conditions is true:

15. Why would the Depreciation & Amortization number on the Income Statement be different from what’s on the Cash Flow Statement?

This happens if D&A is embedded in other Income Statement line items. When this happens, you need to use the Cash Flow Statement number to arrive at EBITDA because otherwise you’re undercounting D&A.

The Difference Between Accrued Revenue & Accounts Receivable

Related

Accounts receivable are invoices the business has issued to customers that have not been paid yet. Accrued revenue represents money the business has earned but has not yet invoiced to the customer.

What is Accrued Revenue?

What is an Account Receivable?

Which Companies Have Accrued Revenue?

Just about any business that supplies goods or services before receiving payment will have accounts receivable. Accrued revenue is common in companies that don’t send invoices on a constant basis, which includes many service businesses, as well as those that earn revenue in stages but don’t bill until a project is completed. Manufacturers, retailers and other businesses that send invoices with shipments tend not to have accrued revenue, since their revenue is billed as soon as it’s earned.

The Difference is Important

Accrual-basis accounting aims to accurately portray a company’s business activity. Under the alternative, cash accounting, a company records revenue only when it receives cash payment from customers. That can give the impression that the company’s revenue is «lumpy,» meaning it goes long periods without earning any money at all.

The accrued revenue and accounts receivable entries in accrual accounting allow the company to recognize revenue and place it on the balance sheet as it earns the money. It should be noted that companies that use cash accounting still track accounts receivable – outstanding bills to customers. They just can’t record the revenue and put it on the balance sheet until bills are paid.

Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens»publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.