Proper bookkeeping and accounting is crucial for small and medium-sized businesses like yours. You need to be able to get a clear picture of your company’s financial situation at any time, and you also need to be confident that your tax affairs are in order.
However, the situation becomes more complicated if you agree to pre-payment. Deferred income is the end result of this scenario. I am guessing that term sounded a little strange. So, we’ll define “deferred income” and discuss how to factor it into your books in the course of this article.
What Is Deferred Income?
Deferred income can also be referred to as deferred revenue or unearned income. As the name implies, it refers to income you have received or have not yet earned. Typically, this is due to a customer or client making an advance payment for services that have yet to be rendered or goods that have yet to be delivered.
Deferred income can help you maintain a healthy gap between your top and bottom lines. However, it is critical to remember that it is a liability and must be accounted for. When you start thinking of deferred income as liquid cash to spend, you open yourself up to potential cash flow issues.
How Deferred Income Works
Deferred revenue is recorded as a liability on a company’s balance sheet when it receives an advance payment. This is because it owes the customer something in the form of goods or services. Because there is still the possibility that the good or service will not be delivered or that the buyer will cancel the order, the payment is considered a liability to the company. Unless otherwise specified in a signed contract, the company would be required to repay the customer in either case.
Contracts can specify different terms, such as no revenue being recorded until all services or products have been delivered. In other words, the payments received from the customer would be deferred revenue until the customer received the total amount due under the contract.
Generally accepted accounting principles (GAAP) require certain accounting methods and conventions, which encourage accounting conservatism. Accounting conservatism ensures that the company reports the most minor profit possible. A company that reports revenue conservatively will only recognize earned income after completing specific tasks to fully claim the money and when the likelihood of payment is certain.
Read Also: NET PROFIT: Meaning, Formula, Ratio & Difference
Deferred revenue is typically gradually recognized on the income statement as a company delivers services or products to the extent the revenue is “earned.” Too quickly categorizing deferred revenue as earned revenue or simply skipping the deferred revenue account and posting it directly to revenue on the income statement is considered aggressive accounting and effectively overstates sales revenue.
Because pre-payment terms are typically for 12 months or less, deferred revenue is commonly reported as a current liability on a company’s balance sheet. However, if a customer made an up-front pre-payment for services that are expected to be delivered over several years, the portion of the payment that pertains to services or products to be provided after 12 months from the payment date should be classified as deferred revenue on the balance sheet’s long-term liability section.
Deferred Income Example
Deferred income is expected with subscription-based products or services that require pre-payments. Rent payments received in advance, pre-payment for newspaper subscriptions, annual pre-payment for software use, and prepaid insurance are all examples of unearned income.
Consider a media company that receives a $1,200 advance payment from a customer for an annual newspaper subscription at the start of its fiscal year. When the payment is received, the company’s accountant records a $1,200 debit entry to the cash and cash equivalent account and a $1,200 credit entry to the deferred revenue account.
The company sends the newspaper to its customers monthly and recognizes revenue as the fiscal year progresses. The accountant records a $100 debit entry to the deferred revenue account and a $100 credit entry to the sales revenue account every month. The deferred revenue balance of $1,200 had been gradually booked as revenue on the income statement at $100 per month by the end of the fiscal year. The balance in the deferred revenue account is now $0 until the pre-payment for next year is made.
Why Do Businesses Record Deferred Income?
The simple answer is that they must go due to revenue recognition accounting principles. They are classified as liabilities in accrual accounting or a reverse prepaid expense because the company owes the cash paid or the goods/services ordered.
Customers’ payment timing can be volatile and unpredictable, so it makes sense to disregard cash payment timing and recognize revenue when it is earned.
Tips on Managing Deferred Income
It’s simple to manage your cash flow and better understand your finances once you’ve developed the habit of adequately accounting for deferred income. Here are some helpful hints for managing deferred income:
- Remember that your income is deferred net of VAT (if you have it registered). VAT is owed to HMRC as of the invoice’s tax point date and is payable by your client.
- Make it a habit to reconcile deferred income regularly to maintain a healthy cash flow and gain a better understanding of your assets.
- Auto-reverse deferred income at the start of each month to avoid missed accruals.
Deferred Revenue vs Recognized Revenue
Deferred revenue is revenue you expect to receive from a booking but have yet to deliver on the account’s agreement. As a result, even though you received the revenue in your account, it cannot be considered revenue. On the other hand, recognised revenue refers to the point at which a booking or deferred revenue becomes actual revenue for your company after fulfilling the agreement as promised. It is added to your account receivables.
Assume you have a converted customer who books your annual SaaS subscription services for $12,000 ($1000 per month) in January. From the standpoint of SaaS accounting, you will not earn that revenue until you deliver what you sold to the customer. The $12,000 deferred revenue is converted into income gradually as the subscription progresses. As a result, you recognize earning $1000 from the account each month.
Is Deferred Revenue Considered a Liability?
Technically, deferred revenues are not revenue until they are earned—you deliver the products or services in advance. As a result, these revenues cannot be reported on the income statement. Instead, you will record them as a liability on your balance sheet.
Just because you have deferred revenue in your bank account does not guarantee that your clients will not request a refund in the future. Furthermore, some industries have strict rules governing how deferred revenue is treated. For example, to fulfill their fiduciary and ethical obligations, lawyers must deposit unearned fees into an IOLTA trust account. Noncompliance can result in severe penalties, including disbarment.
How to Report Deferred Revenue
Businesses must record deferred and recognized revenue because revenue recognition principles require it. Deferred revenue is classified as a reverse prepaid expense (liability) in accrual accounting because a business owes the cash received or the service or product ordered.
In accrual accounting, revenue is only recognized when earned, as opposed to cash accounting, where revenue is only realised when a payment period is received. As a result, if customers pay for products or services in advance, you cannot record any revenue on your income statement under accrual accounting. Instead, your balance sheet will record the payment as a liability.
Assume your company offers SaaS software to customers via subscription with a one-year plan that you divide into $8.99 monthly payments. Customers will choose to pay in advance for the entire first year of a subscription valued at $107.88. You will defer this revenue until they have used the service for an entire year. As a result, your accounting team will recognize 1/12 of the deferred income of $107.88 per month because you have delivered that proportion of your service.
Is Deferred Revenue Beneficial or Detrimental?
Deferred revenue is neither beneficial nor detrimental. So the correct answer is that it depends—mostly on a company’s revenue recognition tracking systems, which correctly track and assign pre-payments as deferred (unearned) revenue or recognized revenue.
Is Deferred Revenue an Accounting Debit or Credit?
Because deferred revenue is a liability until the products or services are delivered by the booking agreement, you will record an initial credit entry on the right side of the balance sheet under current liability (if the sale is less than 12 months) or long-term liability. Then, as revenue is earned, debit the deferred revenue account and credit the revenue account.
Why Is Deferred Revenue Considered a Liability?
As previously stated, deferred revenue is classified as a liability rather than an asset. Here are other reasons why this is so.
Your Investment Is Not Realized
You must still provide your customers with the required service/goods for the completed transaction. As a result, it cannot be considered revenue simply because it appears in your bank records. If your customer wishes to cancel the service before the unfulfilled subscription period, you must refund the sum. (For example, if they cancel the subscription after five months, the money for the remaining seven months should be returned.)
Prevents Overvaluation of Businesses
Calculating growth based on money in your bank before the promised service is delivered is simple. This obscures your company’s forecasting methods and results in a “growth illusion.”
This can lead you to believe you’ve grown and begin investing the unrecognized balance in maintaining your growth momentum. This misleads your investors into thinking you’re growing when the opposite is true.
Provides a Variety of Services
Some businesses provide multiple services in addition to their subscription model, such as annual two-year maintenance. In this case, one part of the service you’re providing is fulfilled at purchase, while the other is delayed. As there are multiple delivery stages, this will show that one part of your revenue is earned and another is deferred, causing accounting issues. Recognizing these accounts may result in false positives in your cash-flow statements. As a result, keeping track of your contract terms with your customers before realizing revenue is critical.
Taking the Next Step
Accounting for deferred revenue is a meticulous process. Recognizing revenue before it is earned will cause your growth numbers to be misinterpreted, potentially increasing your growth potential.
It is also critical to understand that this unearned cash should not be invested in future projects until earned. A more conservative approach to revenue calculation will provide a more realistic picture of your company’s growth.
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