What Is a Deferred Liability in Accounting?
Learn what deferred liabilities are in accounting. Understand how companies account for future financial obligations and their impact on financial reporting.
A deferred liability represents an obligation where a company has received payment or a benefit, but the corresponding goods or services have not yet been delivered or the expense has not been fully incurred from an accounting perspective. This concept is fundamental to how businesses manage their financial records, ensuring that income and obligations are accurately reflected over time. It signifies a future outflow of economic benefits, typically cash, goods, or services, to settle a present duty.
Defining Deferred Liabilities
A liability signifies a financial obligation a business must fulfill in the future, often by transferring economic benefits like money, goods, or services. The “deferred” aspect of these liabilities arises because, under the accrual basis of accounting, revenues and expenses are recognized when they are earned or incurred, rather than when cash changes hands. This method provides a more accurate view of a company’s financial status by matching revenues with the expenses incurred to generate them.
Deferred liabilities primarily emerge under two conditions. First, cash may be received for goods or services that have not yet been provided. For instance, a customer might pay in advance for a subscription or a future service. Second, an expense may have been incurred, but its benefit will be realized over future periods, or the payment is not yet due, thereby creating a future obligation. These differences mean that while an obligation exists due to past transactions, its settlement, whether through service delivery or payment, is postponed to a later period.
Common Deferred Liability Examples
One frequent example is deferred revenue, also known as unearned revenue. This occurs when a company receives cash for products or services it has not yet delivered. Common scenarios include customers paying upfront for software subscriptions, gym memberships, or magazine subscriptions. Gift card sales also create deferred revenue, as the company receives cash but only earns the revenue once the gift card is redeemed.
Another significant deferred liability is the deferred tax liability. This arises due to timing differences between a company’s financial accounting profit and its taxable profit. For example, accelerated depreciation for tax purposes may reduce current taxable income, while slower depreciation (e.g., straight-line) is used for financial reporting. This difference means a company pays less tax now but will owe more tax in the future as the temporary difference reverses. These liabilities represent future tax payments.
Accounting for Deferred Liabilities
Deferred liabilities are presented on a company’s balance sheet under the liabilities section. They can be classified as current liabilities if the obligation is expected to be settled within one year or the operating cycle, or as long-term liabilities if the settlement period extends beyond one year.
When a company initially receives cash for services or goods yet to be delivered, it records this as a deferred liability. For instance, if a business sells a one-year service contract for $1,200 and receives full payment upfront, it initially records $1,200 as a deferred revenue liability. As the service is provided over time, this deferred liability is systematically reduced. Each month, $100 of the deferred revenue is recognized as earned revenue on the income statement, reducing the liability on the balance sheet. This process ensures that revenue is matched with the period in which it is actually earned, providing an accurate view of the company’s financial performance.
Similarly, a deferred tax liability is reduced as the underlying temporary differences between accounting and tax income reverse. For example, if a company’s tax depreciation eventually becomes less than its financial depreciation, the deferred tax liability decreases, reflecting future tax payments becoming due. The recognition of deferred liabilities and their subsequent reduction ensures that financial statements accurately reflect a company’s obligations and its true earnings over time.