Cash Is Not the Same Thing as Earning It
A customer pays you £12,000 in October for a year of support that runs to the following September. The money clears. The bank balance is real. Most business owners look at that and see £12,000 of income.
It is not. On the day the money arrives you have earned none of it. You have taken a customer's cash and given them a promise. Until you deliver the year of support, that £12,000 is an obligation, and accounting treats it as one.
Deferred income is money received in advance for goods or services you have not yet provided. You will also see it called deferred revenue, income in advance or unearned revenue. They all mean the same thing. It sits on the balance sheet as a liability and is released into the profit and loss account as you actually earn it.
It is one of the most commonly mishandled figures in small company accounts, and one of the few where getting it wrong distorts almost everything a reader cares about: profit, margin, growth rate and cash position, all at once.
Is Deferred Income a Liability?
Yes. Always, and for a reason worth understanding rather than memorising.
A liability is an obligation to transfer economic benefit to somebody else. When a customer pays you up front, you owe them something. If you fail to deliver, they are entitled to their money back. Even if they are not, you have committed resources you have not yet spent. The obligation is real, it is measurable and it is owed to a third party. That is a liability by definition.
The confusing part is that most liabilities are settled in cash and this one is settled in work. It sits on the same side of the balance sheet as your trade payables, but you discharge it by delivering the service, not by making a payment.
Where it appears in a set of UK accounts depends on the format, and there is more variation than people expect:
- Most commonly inside creditors falling due within one year, under the heading "accruals and deferred income". This is the Companies Act balance sheet format and it is why that phrase turns up in filed accounts so often.
- Sometimes as a separate line called deferred income, which is clearer for the reader and which we prefer.
- Split between current and non-current where the contract runs beyond twelve months. A three year licence paid up front has two thirds of the balance sitting in creditors falling due after more than one year.
That last split matters more than it looks. It moves a large number out of current liabilities, which changes your current ratio and your working capital position. We have seen businesses fail a covenant test purely because a multi-year prepayment was dumped entirely into current liabilities when most of it belonged further down.
Deferred Income, Accrued Income, Accruals and Prepayments
These four are the same idea applied to four different situations, and confusing them is normal. The question is always the same: has the cash moved, and has the work been done?
| Expense side | Income side | |
|---|---|---|
| Belongs to this period, cash has not moved | Accrual (liability) | Accrued income (asset) |
| Cash has moved, belongs to a future period | Prepayment (asset) | Deferred income (liability) |
Accrued income is the mirror of deferred income. You have done the work but not been paid or even invoiced. It is an asset, sitting close to your trade receivables, the difference being that a receivable normally has an invoice behind it while accrued income does not yet.
Deferred income is the opposite corner. Paid but not delivered. Liability.
If you want the full picture of all four corners, including the expense side, our guide to accruals and prepayments covers the set. This article stays on the income side, because that is where the money, the VAT and the arguments are.
The Double Entry
The mechanics are simple. What trips people up is remembering to reverse them.
When the cash comes in (or the invoice is raised, if earlier):
| Debit | Credit | |
|---|---|---|
| Bank or trade receivables | £12,000 | |
| Deferred income (balance sheet) | £12,000 |
Nothing has touched the profit and loss account. Revenue is zero at this point.
Each month, as you deliver:
| Debit | Credit | |
|---|---|---|
| Deferred income (balance sheet) | £1,000 | |
| Revenue (profit and loss) | £1,000 |
Twelve of those and the liability is back to nil, with £12,000 sitting in revenue where it belongs. This is ordinary double entry bookkeeping with a timing rule attached.
A Worked Example at a Year End
Take that £12,000 support contract. Invoiced 1 October 2026, covering the twelve months to 30 September 2027. Company year end is 31 December 2026.
By 31 December you have delivered three months. So:
- Revenue recognised in the year to 31 December 2026: £12,000 × 3/12 = £3,000
- Deferred income carried on the balance sheet at 31 December 2026: £9,000
- Of that £9,000, all falls due within twelve months, so it stays in current liabilities.
If the same business booked the full £12,000 as revenue in 2026, it would report £9,000 of profit that has not been earned, pay corporation tax on it a year early, and then face a 2027 in which £9,000 of work has to be delivered with no income attached to it at all. Both years are wrong. Only the total is right.
The VAT Trap Nobody Warns You About
This is the part that costs real money, and it catches out almost every business that moves to annual billing for the first time.
VAT does not wait for you to earn the income. For a payment received in advance, the tax point is the earlier of the date you receive the payment and the date you issue a VAT invoice. Not the date you deliver. Not the date you recognise the revenue.
So on that £12,000 contract, if you invoice £12,000 plus £2,400 of VAT on 1 October, the entire £2,400 falls into your October to December return. You recognised £3,000 of revenue in that period and you paid VAT on £12,000 of it.
The accounting and the VAT have deliberately different timing rules and they will not agree. That is not an error to be fixed, it is how the two systems work. What you have to do is plan for it:
- The cash you received is not all yours. A slice is the customer's money and a slice is HMRC's.
- If you take a large advance in the last month of a VAT quarter, the VAT is due within weeks while the revenue trickles in over a year.
- The cash accounting scheme can help here for smaller businesses, since it moves the VAT point to receipt of payment, but for advance payments the cash has already been received, so it offers less relief than people hope.
Refundable deposits are different. A genuine security deposit, taken to cover damage and returned when the goods come back intact, is not consideration for a supply. There is no tax point when you take it and it is not deferred income either. It is a straight liability, money you are holding for somebody else. The moment you apply it against a supply, both the VAT and the revenue position change. Businesses that hire equipment out get this wrong constantly.
Corporation Tax Follows the Accounts
There is good news attached to the VAT bad news. For corporation tax, taxable trading profit is worked out in accordance with generally accepted accounting practice, subject to specific tax adjustments. Deferring income is not a tax scheme, it is just the correct accounting, and the tax follows it.
That means income properly deferred to next year is taxed next year. A business that has been booking all its advance receipts as revenue on day one has been paying tax roughly a year early, sometimes for years. Correcting it is not a tax saving, it is a one-off timing benefit as the position unwinds, and it needs handling properly rather than quietly changing the treatment and hoping nobody asks.
What we would flag: if your deferred income balance moves sharply for the first time, that movement will show up in your accounts and it deserves a sentence of explanation. A large new liability that appeared without a corresponding change in the business is exactly the kind of thing that attracts a question, whether from HMRC, a lender or a buyer.
What Changes in 2026: The New FRS 102 Revenue Model
For accounting periods beginning on or after 1 January 2026, the way UK companies recognise revenue changed. FRS 102 Section 23, and the equivalent section of FRS 105, were rewritten and retitled Revenue from Contracts with Customers. They now follow a simplified version of the five step model used in IFRS 15.
The five steps:
- Identify the contract with the customer.
- Identify the performance obligations in it, meaning the distinct promises you have made.
- Determine the transaction price, including any variable element such as discounts, rebates or bonuses.
- Allocate the transaction price to each performance obligation, normally in proportion to standalone selling prices.
- Recognise revenue as each performance obligation is satisfied, either over time or at a point in time.
The underlying test has shifted from risks and rewards to transfer of control. In practice, for a straightforward sale of goods or a simple monthly service, nothing much changes. Where it bites is contracts with more than one thing in them.
Why Step 2 Is the One That Will Catch People
Here is a case we expect to see repeatedly. A business sells a package for £12,000: a one-off setup and then twelve months of support. Historically most would spread £12,000 evenly over twelve months and call it done.
Under the five step model you have two performance obligations, and you allocate the price across them using standalone selling prices. Say setup normally sells for £3,000 and support normally sells for £12,000, a total of £15,000 against a £12,000 bundled price:
- Setup: £12,000 × (3,000/15,000) = £2,400, recognised when the setup is complete.
- Support: £12,000 × (12,000/15,000) = £9,600, spread over twelve months at £800 a month.
Three months into the contract, at a 31 December year end, you have recognised £2,400 + £2,400 = £4,800, with £7,200 deferred. The old even-spread approach gave £3,000 recognised and £9,000 deferred.
That is £1,800 of extra revenue in year one on a single £12,000 contract. Multiply by a full sales ledger and it is not a rounding difference. It also front-loads profit in a way that looks like growth when it is really just a change in accounting policy, which is worth saying out loud to your bank before they ask.
This One Reaches Micro-Entities Too
Worth flagging if you followed the other big 2026 change. When lease accounting was rewritten, FRS 105 was left alone, so micro-entities carried on as before.
Revenue is not like that. The five step model, in a further simplified form, has been brought into FRS 105 as well. If you file micro-entity accounts and you have bundled contracts, staged delivery or payments in advance, this applies to you. A lot of micro-entity accounts are prepared on the assumption that nothing ever changes at that end of the scale. This year, that assumption is wrong.
Transition
Most companies will use the modified retrospective approach: you do not restate the comparative year, you assess the contracts still live at the transition date and put the cumulative catch-up through opening retained earnings. Full retrospective restatement is available where practicable, and there are practical expedients including the use of hindsight for variable consideration and contract modifications.
The point to watch is the same one that bit people on leases. A cumulative adjustment that lands in retained earnings changes your distributable reserves before you have traded a single day of the new year. Check it before you declare a dividend.
Where Businesses Get This Wrong
From accounts we have picked up over the years, in rough order of frequency:
- Everything booked as revenue on receipt. The most common by far. The business shows a spectacular quarter when the annual renewals land and a terrible one three months later. Nothing about that pattern is real.
- The journal is posted once and never reversed. Somebody defers the income correctly at the year end, and then nobody releases it monthly. Next year's revenue is understated instead, which is a different flavour of the same problem.
- No schedule behind the balance. The nominal ledger says £84,000 of deferred income and nobody can produce the contract-by-contract list that makes up the figure. If you cannot rebuild the number from source, it is not a balance, it is a guess.
- Refundable deposits treated as deferred income. Two different liabilities with two different VAT positions, merged into one heading.
- Setup fees spread over the service period out of habit, rather than allocated properly across performance obligations. That is now the wrong answer as well as an imprecise one.
- The deferred income release stops when the customer cancels, but the remaining balance is never dealt with. If a customer walks away and you keep the money under a non-refundable term, that balance becomes revenue at the point the obligation ends. Leaving it parked as a liability forever is not conservative, it is wrong.
Our View
Deferred income is the most honest line on a small company balance sheet, and the least popular. It is the only figure that stops a business congratulating itself for money it has taken but not earned. Every owner we have explained it to has been slightly deflated by it, and every one of them has run the business better afterwards, because they finally knew what a month was actually worth.
Your bank balance is lying to you, and this is how much by. In a business that bills annually, a chunk of the cash sitting in the account belongs to customers whose work is still ahead of you, and another chunk belongs to HMRC as VAT. Our rule of thumb: if the deferred income balance is growing faster than revenue, you are not becoming more profitable, you are becoming better funded by your customers. That is a real and valuable thing, but it is not profit and it should not be spent like profit. Model it properly in your cash flow forecast.
Software will not do this for you. Xero and QuickBooks do not defer income on their own. Whatever the app store claims, in practice this is a monthly journal driven by a schedule somebody maintains by hand. So treat the schedule as the source of truth and reconcile the nominal ledger to it every month, the same way you would a bank account. The businesses that get deferred income right are not the ones with better software, they are the ones doing a five minute reconciliation twelve times a year.
If you might ever sell the business, this line is worth money. Buyers almost always treat deferred income as debt-like in completion accounts, because it is an obligation to deliver services funded by cash that has already been spent. If your accounts do not show it, due diligence will construct it, and the adjustment will arrive late in the process when your negotiating position is at its weakest. A company that has been recognising advance receipts as revenue also has an inflated EBITDA, which gets normalised downward at exactly the same moment. You get hit twice on the same mistake. Anyone thinking about an exit should read our guide to how a business is valued with this in mind.
On the new five step model, our honest opinion: it is heavier machinery than most small businesses need, and the disclosure burden for a company with one product and monthly billing buys nobody anything. But the principle underneath it is right, and step 2 in particular forces a question that businesses selling bundles should have been asking all along, which is what exactly the customer is paying for and when they get it. If the standard makes people answer that question, it will have earned its keep. Just do not expect the answer to flatter your first year.
How IAK Can Help
Most of our deferred income work starts the same way: the client has a number in the accounts and no schedule behind it. We build the schedule, contract by contract, agree it to the ledger, and then set up a monthly release journal that runs without anybody having to think about it.
Our accounting team prepares statutory accounts under the amended FRS 102 and FRS 105, including the Section 23 assessment, the transition adjustment and the disclosures. Our bookkeeping and Xero teams handle the monthly journals and the reconciliation so the balance is right all year rather than fixed once at the year end. Our management reporting team makes sure your monthly numbers reflect earned revenue, not cash received, which is usually the moment a business owner first sees their real trading pattern. Our VAT advice team deals with tax points on deposits and advance payments, and our tax planning team handles the corporation tax timing when a treatment is being corrected.
We do a lot of this for small businesses on subscription or retainer models, and for affiliate and content websites where advance sponsorship payments raise exactly the same question.
If you take money before you deliver, and most businesses do somewhere, get in touch for a free consultation. It usually takes one conversation to work out whether your deferred income is a five minute monthly job or a genuine problem.
Sources
- FRC revises UK and Ireland accounting standards, Financial Reporting Council, on the Periodic Review 2024 amendments and the 1 January 2026 effective date.
- FRS 105 The Financial Reporting Standard applicable to the Micro-entities Regime, Financial Reporting Council, on the standard as amended.
- New revenue recognition model for FRS 102 and FRS 105, ICAEW, on the five step model being brought into both standards with simplifications.
- FRS 102 amendments, revenue recognition, ICAEW, on the rewritten Section 23 and its application.
- FRS 102 amendments to revenue accounting, where should you start, BDO, on the five steps, the shift from risks and rewards to control, the transition options and the practical expedients.
- FRS 102 revenue accounting changes 2026, Forvis Mazars, on the sectors most affected and the FRS 102 simplifications including the choice on time value of money for consideration received in advance.
- VAT guide (Notice 700), HMRC, on time of supply and accounting for VAT in the period in which the tax point occurs.
- Corporation Tax Act 2009, section 46, legislation.gov.uk, on trading profits being calculated in accordance with generally accepted accounting practice, subject to any adjustment required by law.