Deferred Revenue & Working Capital

Although deferred revenue is classified as a "current liability" on your company's balance sheet, it's not like most liabilities, in that it doesn't represent money you will have to pay. Instead, it represents money you will have to earn. Deferred revenue is a factor in your company's working-capital calculations, but its role is different from other current liabilities.

Deferred revenue is cash that a company has received but has not yet earned, typically a customer prepayment. In accrual accounting, you can't book revenue until you've done everything you need to do to earn it. Deferred revenue, also called unearned revenue, goes on your balance sheet as a liability, because it represents a future obligation -- in this case, to provide whatever good or service your customer has prepaid for. Deferred revenue goes down as a current liability, meaning it's an obligation that will be settled within a year.

The general definition of net working capital, commonly called just "working capital," is the difference between a company's current assets and its current liabilities. (Current assets include cash and assets that the company expects to turn into cash within a year, such as inventory and accounts receivable.) You typically want to have positive working capital, since it means you'll have the cash to meet your immediate obligations. Deferred revenue's effect on net working capital is in many ways a "wash." Say you have $15,000 in current assets and $10,000 in current liabilities. You therefore have $5,000 in net working capital. If a customer gives you a $500 prepayment, that's deferred revenue, which increases current liabilities by $500. But the cash the customer gave you is a current asset, so current assets rises by $500, too. There's no change in net working capital.

The math of working capital is sometimes misleading, and deferred revenue provides an example. Current liabilities are short-term obligations, and in most cases, those obligations are bills to be paid -- impending demands for cash. For example, accounts payable, a big chunk of the typical company's current liabilities, are bills from suppliers. Accrued liabilities include things like wages your employees have earned but haven't yet been paid. With deferred revenue, though, there's no demand for cash. Your obligation is to provide goods, which may mean pulling something out of inventory, or to provide a service. In the meantime, you already have the customer's cash. You don't have to keep that cash set aside until you've "earned" it and booked the revenue. You can use it right now to meet other obligations.

One way to think of current liabilities is that you're using other people's money to finance your operations. When you buy inventory on trade credit, for example, the supplier is essentially lending you the money for the goods. And until you pay the bill (accounts payable), the supplier's money is in your business, where you can use it to generate sales revenue. Similarly, when a customer prepays, you get the cash right away. This deferred revenue isn't truly "yours" yet -- it hasn't been earned -- but you can use it to generate sales revenue. Thus, the customer's money is financing your operations.