DEFERRED REVENUE: Definition & How it Works

Deffered revenue
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Businesses usually receive an upfront payment from a customer to deliver goods and services at a particular time. These are goods that are not yet ready or services that the company is yet to perform. When this is done, the company records the transaction as a liability in the journal entries. Thus, the company has earned revenue but is liable to the client. In this article, we will understand why deferred revenue is recorded as a liability in an income statement and also how to record deferred revenue in journal entries.

What Is Deferred Revenue?

Deferred revenue, also known as “unearned” revenue, is an upfront payment a company collects from its customers before earning it. The company records it as a liability under accrual accounting on the balance sheet because the revenue recognition process is not yet complete. When it is completed, the company can now record it on the income statement as accrual accounting. When a customer pays in advance for goods or services, the company does not record revenue on its income statement. Instead, it records the revenue as a liability on the balance sheet.

How Deferred Revenue Works

When a company receives a down payment from its client, it will record it as a liability on the company’s balance sheet. This is because it owes the customer something in the form of goods or services. The company records it as a liability because there is still the possibility that the product or service will not get to the customer or that the buyer will cancel the order.

However, if the payment is specified in a signed contract, the company would have to repay the customer. Contracts imply that the company may not record any revenue until the complete delivery of the goods and services. So, down payments from the customer would be deferred revenue until the customer receives the full amount due under the contract. 

Furthermore, a company records deferred revenue on the income statement gradually as it delivers the services or products, till it earns the revenue. Then the company will begin to over-classify or skip the deferred revenue account, posting it directly on the income statement. The accounting will become assertive and virtually overstate the sales revenue. 

Why Do Companies Record Deferred Revenue?

#1. The Company Still Owes the Client

Companies record deferred revenue because they still owe their customers. According to revenue recognition accounting principles, they are classified as liabilities in accrual accounting or a reverse prepaid expense because the company still owes the customer either the cash or the goods/services.

#2. Customer’s Timing is Unpredictable

Customers’ payment timing can be unpredictable and may vary. So it makes sense to disregard cash payment timing and recognize revenue when the company earns it. Remember that just because the money is in your bank account does not mean your client will not request a refund in the future.

#3. It Keeps You From Overrating Your Business.

The reason that deferred revenue is classified as a liability is to ensure that your financial records do not overstate the value of your company. This enables investors to see that you clearly state your assets and liabilities in your financial records. Following that, GAAP rules to make sure that you are not recording liabilities (such as deferred revenue) as assets prematurely (like cash).

What Are Deferred Revenue Journal Entries?

“Deferred revenue journal entries” are financial transactions for recording earnings from a product or service that has yet to be delivered. When a customer prepays a company for goods and services, the company will record the transaction in the journal entries. Deferred revenue is a common occurrence in financial accounting, and recording it in the company’s journal entries makes the action visible in the financial statements. However, the journal entries are your accounting’s tracking mechanism for this type of revenue. You can recognize your revenue only when you earn it. It is a liability account that shows your obligation to your customer. The journal entry becomes real revenue when your company delivers the goods or services.

How to Record Deferred Revenue

When you record deferred revenue, you create a debit on your assets and a credit on your liabilities. Hence, you recognize the revenue in your journal entry; the account is debited and your income statement is credited. 

When a company receives deferred revenue, it’s important to record the transaction using the proper journal entry method. This is simple to compute. For instance, when a customer pays the company before receiving a product or service, the account in the journal entry grows. You can be sure to record your transactions using the following recording methods:

Example

Consider this example of a customer paying upfront for a company to design their website and brand. The company needs to estimate the work, which might cost around $200, so the customer pays in advance and expects the services to be due in 30 days. In this case, you can record the $200 deposit in the general ledger as debit cash at $200 and $200 deferred credit revenue.

Assume the company completes the project and discovers that it only costs $150 to meet the customer’s requirements. In this case, the company offers the customer a refund of the extra $50 from the deposit. You can now record in your journal entry to account for the final project and refund as deferred revenue is $200, revenue is $150, and cash is $50.

However, if the customer requests additional work after providing the deposit, the work cost about $500. The customer’s request implies that the company bills them for the remaining balance. You can now record the in your journal entry to account for the account receivables as Deferred revenue of $300, accounts receivable of $200, and credit revenue of $500

How to Recognize the Revenue and Apply the Excess to the Receivables Account

The following is how to recognize the revenue and apply the excess to the receivables account.

#1. Determine How Long the Company Intends to Deliver the Product or Service.

The first step is to determine when the company intends to deliver the product or service to the customer who has paid for the item. There are two options. The first is that the company will deliver the product or service within the next 12 months. 

If so, then you can record deferred revenue as a current liability. The company’s second option is to deliver the item to the customer after 12 months. In this case, the company records the deferred revenue as a long-term liability on the company’s balance sheet. 

#2. Keep a Record of the Customer’s Payment.

When the customer makes the payment, record it as a journal entry. From the first step, the revenue will either be a current or long-term liability on the balance sheet. Then, using this information, you can create the appropriate financial transactions in the proper areas of the company’s balance sheet. Let’s look at examples of delivery within 12, delivery beyond 12, and mixed delivery.

  • Example of delivery within 12 months: When creating journal entries, if the company expects to deliver the goods within 12 months, you can either debit cash or credit deferred revenue.
  • Example of delivery beyond 12 months. This method is similar to recording a journal entry of delivery within 12 months. When the company expects to deliver the goods beyond 12 months they can debit cash and credit non-current deferred revenue. You can create the journal entries for the revenue by dividing them into two categories. That is if the company expects to deliver the goods within or after 12 months. Assume a customer pays in advance for a $300 two-year magazine subscription. $300 in cash, $150 in deferred revenue, and $150 in non-current deferred revenue

#3. Adjust Revenue as the Company Delivers the Goods

Finally, as the company delivers the goods or services, it will adjust the deferred revenue account. The company provides the goods, so they have to record the revenue by creating another general ledger journal entry. For example, if a customer pays in advance for an item and the company delivers it in full at the exact price, you can enter an adjustment entry. If the customer pays upfront, the company may owe more money or refund the money. Let’s understand this basic adjusting journal entry example.

Assume a customer pays for a magazine subscription in advance. The customer has already made the first journal entry, transferring the revenue to the proper account. You want to recognize and create a deferred revenue adjusting journal entry each month as the company delivers the magazine to the customer as debit deferred revenue at $10 and credit revenue at $10.

Deferred Revenue FAQs

Is deferred revenue an asset or expense?

Deferred revenue will be recorded as a liability rather than an asset on your company’s balance sheet. Receiving a payment is typically regarded as an asset. Prepayments, on the other hand, are liabilities because you still owe something to a customer.

Is deferred revenue taxable?

Deferred revenue is unimportant for businesses that report taxes on a cash basis. This is because companies report their income in the year they receive it. Accrual basis taxpayers, on the other hand, can postpone paying tax on the revenue until a later tax year.

How does deferred revenue affect cash flow?

The impact of cash flow changes in deferred revenue happens in the cash flow statement’s operation section. When deferred revenue increases there is a cash inflow; when it decreases, there is a cash outflow.

What is the difference between deferred revenue and accrued revenue?

Deferred revenue, also known as unearned revenue, refers to the down payment a customer makes to receive goods or services in the future. While accrued expenses are those that are recorded on the books before they are paid.

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