How does a company account for cash payments received in advance of delivering its goods or services?
Under the "accrual-basis accounting" rules used by most companies, advance payments can't be counted as revenue because the company hasn't "earned" the money yet by delivering the goods or services.
But the cash has to be accounted for somewhere in the company's financial statements. Until it's earned, that cash is known as deferred revenue. It's accounted for on both the company's balance sheet and its cash flow statement -- but the entry on the cash flow statement might not be obvious.
How deferred revenue is calculated
Imagine that it's Oct. 1, and you just paid $1,000 for a one-year membership to your favorite gym. The gym's fiscal year ends on Dec. 31, at which point it will have earned only 3 months' worth of your one-year payment, or $250 of the $1,000.
The gym's accountant will record that $250 as income on that year's financial statement. But the remainder, $750, cannot yet be counted as income. It's an asset, because it's cash. But in a sense, it's also a liability, because the gym owes you nine months of services in order to earn that cash. We refer to it as deferred revenue -- cash that the business has not yet earned but is committed to earning as revenue in the future.
How deferred revenue is reported on the balance sheet
The remaining $750 gets reported as both an asset and a liability on the balance sheet. On the assets side of the balance sheet, the accountant adds $750 to the business's total cash. On the liabilities side of the balance sheet, the accountant adds an offsetting $750 under "deferred revenue" to recognize that the gym still owes you nine months' worth of membership.
How deferred revenue is reported on the cash flow statement
The cash flow statement tracks the cash coming into and going out of the company over the period. The gym received a $1,000 payment -- that's cash coming in. And $750 of that cash is deferred revenue.
But that cash might not necessarily show up as "deferred revenue" on the cash flow statement. Some accountants will make a specific entry for "cash received as deferred revenue" or something similar. But many will just roll that payment into a catch-all for cash received from operating activities, perhaps with a title like "Other cash from operations." A small company with simple operations might just report it as cash received, with no more detail offered.
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