Revenue recognition is an accounting principle that governs the circumstances under which a company can record transactions as revenue. Accurate timing in revenue recognition influences financial indicators such as revenue, gross margin, and net income. These indicators serve as benchmarks for stakeholders such as investors, creditors, and regulators to assess the financial strength and trajectory of a business. Incorrect or inconsistent revenue recognition can lead to misrepresentation of a company’s financial condition, potentially misleading stakeholders and resulting in severe legal and reputational repercussions.

The first step in accurate revenue recognition is understanding the two different types of revenue: accrued revenue and deferred revenue. Below, we’ll explain the differences between accrued and deferred revenue, and how to work with both to produce strong revenue recognition practices.

What’s in this article?

• What is accrued revenue?
  
• What is deferred revenue?
  
• What’s the difference between accrued and deferred revenue?
  
• Accounting for accrued revenue
  
• Accounting for deferred revenue
  
• How accrued and deferred revenue affect financial statements
  
• Recognising revenue: Accrual vs. cash accounting
  
• How to manage accrued and deferred revenue using Stripe
  
• Best practices in reporting accrued and deferred revenue
  

What is accrued revenue?

Accrued revenue is income that a company has earned but for which it has not yet received payment. Accrued revenue normally arises in situations where delivery of goods or completion of a service occurs before payment is received.

Accrued revenue is recorded as an asset on the balance sheet, specifically as a receivable, which indicates that the company has a right to receive payment for delivered goods or services. Once the company receives payment, the accrued revenue is realised as cash and the company adjusts its financial records accordingly.

What is deferred revenue?

Deferred revenue, also known as unearned revenue, is money that a company receives for goods or services that it has not yet delivered or completed.

When a company receives payment in advance, the amount is recorded as deferred revenue on its balance sheet under liabilities. This reflects the company’s obligation to deliver products or perform services in the future. As the company fulfils its obligation to deliver goods or services, the deferred revenue is gradually reduced and recognised as actual revenue on the income statement.

What’s the difference between accrued and deferred revenue?

Accrued revenue and deferred revenue are both accounting concepts related to revenue recognition, but they represent opposite scenarios. Here’s how they differ.

Accrued revenue

Accrued revenue is revenue that a company has earned by delivering goods or services but for which it has not yet billed or received payment. This revenue is recognised before cash is received and is recorded as a current asset on the balance sheet.

• Example: A consulting firm completes a project in December but doesn’t invoice the client until January. The revenue earned in December is accrued revenue.
  

Deferred revenue

Deferred revenue is cash that a company receives in advance for goods or services that it will deliver or perform in the future. This revenue is recognised after cash is received and recorded as a current liability on the balance sheet.

• Example: A software company receives an annual subscription payment upfront. This payment is deferred revenue until the software service is provided throughout the year.
  

Accounting for accrued revenue

At the end of an accounting period (for example, at the end of the month), if a company has provided a service but hasn’t been paid yet, it needs to acknowledge that work as revenue in its books. This means making an entry that increases accounts receivable – showing that customers owe money – and also increases revenue. This dual increase shows that the company has earned the money, even though the money is not yet in the company’s bank account.

Recognising accrued revenue as a company earns it helps paint an accurate picture of a company’s financial health during a specific period. For example, if a law firm worked on a big case in June but wasn’t paid until July, it would still record the revenue in June. This way, the firm’s financial statements for June reflect the revenue earned during that period.

To keep track of accrued revenue, businesses must carefully manage invoices and payments to align recorded revenue with completed work and ensure all expected payments are received.

Accounting for deferred revenue

Deferred revenue, or unearned revenue, is payment that a company receives for goods or services before it has delivered them. This is common in industries such as software subscriptions, magazine subscriptions, or any service that is paid for in advance.

When a company is paid upfront, it cannot book the full amount as revenue straight away, even though the cash is in the bank. Instead, it records this advance payment as deferred revenue, which is a liability on the balance sheet. This is because the company now has an obligation to deliver those goods or services in the future.

Recognising deferred revenue helps keep a company’s earnings aligned with its activity. For example, if a gym collects an annual membership fee in January, it can’t claim the full amount as January’s revenue. The gym provides the service (gym access) over the course of the year. Therefore, the revenue is recognised monthly as the service is provided, not when the money is received. In each accounting period, a portion of the deferred revenue is shifted into the earned revenue category. This gradual recognition continues until the obligation is fulfilled.

Managing deferred revenue requires careful tracking of what has been paid for versus what has been delivered. This process is an important part of accurate financial reporting as well as maintaining trust with customers and investors. It ensures that the company doesn’t overstate its earnings by booking all the revenue at once and that financial statements reflect ongoing operations realistically.

How accrued and deferred revenue impact financial statements

Accrued and deferred revenue are both recorded on a company’s balance sheet and income sheet. Accrued revenue recognises revenue when it’s earned, which helps present a more accurate picture of a company’s current financial performance. It boosts current assets and revenue, and it can make the company appear more profitable in the short term. Deferred revenue reflects future obligations and cash received in advance, and it increases current liabilities. This can make the company appear less profitable in the short term, but it also provides a buffer for future revenue recognition.

Here’s how each type of revenue is recorded.

Accrued revenue

Balance sheet

Accrued revenue is recorded as a current asset on the balance sheet under “Accounts Receivable” or as a separate line item called “Accrued Revenue”. This reflects the amount owed to the company for goods or services already delivered.

Accrued revenue ultimately increases retained earnings (a component of equity) as it represents earned income.

Income statement

Accrued revenue is recognised as revenue in the period it is earned, even though cash hasn’t yet been received. This matches revenue with the expenses incurred to generate it, which provides a more accurate picture of profitability.

Deferred revenue

Balance sheet

Deferred revenue is recorded as a current liability on the balance sheet under “Deferred Revenue” or “Unearned Revenue”. This represents the obligation to deliver goods or services in the future for which payment has already been received.

As deferred revenue is earned over time, it is recognised as revenue, which then flows through to retained earnings, increasing equity.

Income statement

Deferred revenue does not affect the income statement when it is initially received. It is only recognised as revenue over time as the company fulfils its obligations. This ensures that revenue is not inflated prematurely.

Recognising revenue: Accrual vs. cash accounting

Recognising revenue in business accounting can be handled in two different ways: through accrual accounting or cash accounting. Each method offers a different perspective on a company’s financial activities, and affects how transactions are recorded and when revenue and expenses are recognised.

Here’s a closer look at each method.

Accrual accounting

Accrual accounting recognises revenue when it is earned and expenses when they are incurred, regardless of when the cash transactions occur. This follows the matching principle, which aims to match revenues with related expenses in the period in which the transaction occurs. Accrual accounting is generally preferred for larger businesses. In the US, the IRS requires businesses with $25 million or more in revenue over a three-year period to use the accrual method.

• Revenue recognition: In accrual accounting, revenue is recognised at the time a product is sold or a service is delivered, even if payment is received at a later date. This method provides a more accurate picture of financial performance during a specific period.

• Expense recognition: Expenses are recorded when they are incurred, not when they are paid. This is important for matching expenses with the revenues they help generate.

• Financial reporting: Accrual accounting offers a comprehensive view of a company’s financial health because it includes receivables and payables.

Cash accounting

Cash accounting is simpler and recognises revenue and expenses only when cash is exchanged. This method is straightforward: money in is income, and money out is an expense. Smaller businesses, particularly those that do not sell on credit, might prefer cash accounting for its simplicity.

• Revenue recognition: Revenue is recognised only when cash is received. For example, if a customer pays for a service in March that was provided in February, the revenue is recognised in March under cash accounting.

• Expense recognition: Expenses are recognised when they are paid, not when they are incurred. This can lead to periods in which expenses can be much higher or lower depending on payment schedules.

• Financial reporting: Cash accounting can give a skewed view of a company’s longer-term financial health because it does not account for money that is owed but not yet received, or for debts that have not yet been paid. However, it offers a clear picture of how much cash the business has on hand at any given time.

How to manage accrued and deferred revenue using Stripe

Stripe offers tools and features to help businesses manage accrued and deferred revenue. Stripe automates many aspects of revenue recognition, which saves time and can help reduce the risk of errors. These features can also help ensure compliance with complex accounting standards such as ASC 606 and IFRS 15.

Here’s how Stripe can help.

Managing accrued revenue with Stripe

• Stripe allows you to create and send invoices for services rendered or goods delivered. You can track the status of these invoices, including when they are sent and paid. This helps you monitor the timing of revenue recognition for accrued revenue.

• Stripe provides detailed reports on your invoices and payments, giving you visibility into your accrued revenue. You can analyse these reports to track the amount of revenue earned but not yet received.

• Stripe integrates with popular accounting software such as QuickBooks and Xero. This integration automatically syncs your Stripe data with your accounting software, which simplifies the process of recording accrued revenue and can help ensure accurate financial reporting.

Managing deferred revenue with Stripe

• Stripe Billing allows you to easily manage recurring subscriptions. You can track the payments received in advance for future services or goods, which constitutes deferred revenue.

• Stripe Revenue Recognition automates the process of recognising revenue over time for subscriptions and other deferred revenue scenarios. This helps businesses adhere to accounting standards such as ASC 606 and IFRS 15.

• Stripe generates revenue schedules that outline the timing and amount of revenue to be recognised for each subscription period. These schedules provide a clear picture of your deferred revenue and its impact on your financial statements.

• Stripe allows you to customise revenue recognition rules to correspond with your specific business model and accounting practices. This flexibility can help create accurate and compliant revenue recognition.

Best practices in reporting accrued and deferred revenue

Here are some best practices for reporting accrued and deferred revenue.

Accrued revenue

• Timely recognition: Recognise accrued revenue in the period when it is earned, even if you have not received payment yet. This matches revenue with related expenses and provides a more accurate picture of financial performance.

• Accurate estimation: Use reliable methods to estimate accrued revenue, considering factors such as contract terms, completion percentages, or time elapsed. This involves applying estimation techniques consistently and documenting assumptions.

• Clear disclosure: Disclose accounting policies for accrued revenue in the footnotes to financial statements. This includes explaining estimation methods, assumptions, and any uncertainties surrounding the accrued amounts.

• Regular review: Review and update accrued revenue estimates regularly, as new information becomes available. This ensures that estimates remain reasonable and reflect the latest information.

Deferred revenue

• Proper classification: Classify deferred revenue as a liability on the balance sheet. This accurately reflects the obligation to deliver goods or services in the future.

• Revenue recognition over time: Recognise deferred revenue as it is earned, usually over the period the goods or services are delivered. You can do this with the straight-line method, percentage-of-completion method, or other appropriate methods.

• Detailed schedules: Maintain detailed schedules for deferred revenue, tracking the original amount, recognised revenue, and remaining balance. This helps with accurate reporting and reconciliation.

• Transparent reporting: Disclose the amount of deferred revenue, the revenue recognition method used, and any major assumptions in the footnotes to financial statements.