Deferred revenue is the unearned revenue for an organization. It is the amount of advance payment that the company receives. However, it is for goods or services which are not yet delivered. It is an amount that is received for something that will happen over time. Any organization that receives prepayment will record it as deferred revenue, which is shown as a liability in the balance sheet. Once the product or service has been delivered, the amount will be recognized as revenue in the statement of income.
- Unearned revenue for the company is known as deferred revenue and it is a liability in the balance sheet of the company.
- It is the prepayment made by customers for products and services not yet delivered.
- When the product is delivered, the amount will be recognized as revenue.
- In deferred revenue, the GAAP guidelines of conservatism are followed.
- When the good or service remains undelivered, the company owes the money to the customer.
Understanding deferred revenue
Deferred revenue is shown on the liability side in the balance sheet. It is the advance payment received by the company. It is an obligation to the third party. This amount is considered as a liability because there will always be a chance that the product will remain undelivered or the customer may call off the order. When this happens, the company needs to repay its customers unless the terms of payment were clearly stated in the contract.
It is possible to create a contract where different terms are stipulated. In that case, no revenue will be reported until the products or services have been delivered. The payment received will be shown as deferred revenue until the good or service has been delivered to the customer as per contract.
GAAP requires accounting methods that promote accounting conservatism. This principle ensures that the company reports the lowest profit possible. When the company reports revenue in a conservative manner, it will only report the earned revenue after the completion of certain tasks. Companies will only record the revenue when they have a complete claim on the money and the payment likelihood is certain.
By categorizing the revenue as earned revenue very quickly by posting directly to the revenue in the income statement is a form of aggressive accounting and can overstate the profit. The prepayment terms are usually less than 12 months and deferred revenue will be shown as a current liability. If the customer makes a prepayment for any service, the part of the payment that applies to products or services to be provided after the completion of 12 months from the date of payment falls under deferred revenue and is shown as a liability in the balance sheet.
Examples of deferred revenue
Common examples include rent payments that are received well in advance, annual prepayment for software, prepaid insurance, or an amount received for the subscription of a newspaper. The other party in the situation will record the advance cash as a prepaid expense in the balance sheet.
Assume that a company receives $1500 in advance at the start of the year from the customer for a newspaper subscription. Once this amount is received, the accountant will record a debit entry in cash and a credit entry in the deferred revenue account. Over the year, the company will send newspapers to customers every month and will recognize revenue. Every month, the accountant will record one debit entry in the deferred revenue account and one credit entry in a sales account of $125. At the end of the year, the total amount will be shown as revenue in the statement of income and there will be $0 balance in the deferred revenue account.
How to record deferred revenue
The revenue will be shown in the balance sheet as a liability. Receiving payment for goods or services not yet delivered is considered an asset. Prepayment is a liability because it is not earned yet and you owe something to the customer. The deferred revenue will only turn into earned revenue when you give the product or service to the customer. Let us take another example here. A customer purchases a $120 magazine subscription for a year. At the time of receipt of money, you need to debit the cash account and credit the deferred revenue account.
|Cash||Payment for magazine subscription||120|
Every month, one-twelfth of the revenue will be the earned revenue. An amount of $10 per month will be the revenue. An adjusting entry should be passed where you debit the deferred revenue account and credit the revenue account.
|Deferred Revenue||One month of magazine subscription||10|