Cash on hand and positive cash flow are crucial to the success of any small business. A business requires cash to pay its bills, employees and other near-term expenses. One way to ensure a company has adequate positive cash flow is to implement effective cash-management techniques. These include quickly collecting on accounts receivables, extending payments to suppliers, obtaining customer deposits and requiring prepayments. Deposits and prepayments are forms of deferred revenue. The operating section of the cash-flow statement captures changes in deferred revenue.
Deferred Revenue Definition
Deferred revenue, another name for unearned revenue, is revenue whose entry onto the income statement is delayed. In accrual accounting generally accepted accounting principles, or GAAP, require that companies recognize revenue when earned and expenses when incurred. When your company receives a customer deposit or prepayment on a sale, that payment occurs in advance of the actual sale and is therefore considered unearned revenue. Deferred revenue flows between the balance sheet and the income statement as revenue. The cash-flow statement captures this flow.
Statement of Cash Flows
The statement of cash flows shows how your company's use assets or creation of liabilities affect cash. It also shows how financing activities and revenue and profit generating activities impact cash. The cash-flow statement contains three sections: operating, investing and financing. Consistent use of customer deposits and prepayments helps achieve positive cash flow by ensuring your company receives cash before it pays out cash.
Cash Flow -- Deferred Revenue
When your company receives a customer deposit, the net income shown at the top of the operating section does not reflect this deferred revenue. Therefore, you record this deferred revenue as a cash inflow in the operating section. Specifically, you adjust cash generated from operating activities upward by the amount of the deferred revenue. When your company provides the service, the net income shown at the top of the operating section now includes the earned revenue. However, it did not obtain actual cash for this revenue in this period. Therefore, you must adjust the operating cash flow downward by the amount of this earned revenue.
Example – Part I
If your law firm receives a $50,000 retainer in April from a corporate client, that $50,000 does not yet show on April’s income statement. It appears on your cash-flow statement for April in the operating section as a $50,000 increase in cash. It also appears on your company's month-ending balance sheet as deferred revenue.
Example – Part II
In early May your client is sued and you prepare a response and commence trial preparation. You bill for $25,000 in services. That $25,000 appears as revenue on your firm's income statement for May. The cash-flow statement for May reflects a $25,000 decrease in cash. The balance sheet as of May 30 shows $25,000 in deferred revenue remaining.