Deferred revenue is unearned income that a business received in advance. It is recorded as a current liability on the balance sheet of a business.
Once the seller delivers the promised goods/services, the current liability is removed and turned into earned revenue in the income statement.
Let us discuss what is deferred revenue, how it works, and why is it a liability.
What is Deferred Revenue?
Deferred revenue refers to the revenue that is received by a business in advance against products or services that are not yet delivered to the buyer.
It is also called unearned revenue because the seller is yet to earn it by delivering the promised products/services to the buyer.
Deferred revenue cannot be recorded as actual income or revenue because it isn’t earned. However, since the seller receives a prepayment, it cannot go unrecorded on the financial statements.
Therefore, the unearned or deferred revenue is recorded as a liability on the balance sheet of the company rather than the income statement. It follows the principles of accrual accounting to record a transaction as and when it happens regardless of the time it is completed.
Deferred revenue is recognized as a short-term liability as the seller expects to complete the transaction within one year by delivering products/services. The amount recorded as deferred revenue can be replenished gradually as well.
How Does Deferred Revenue Work?
Many businesses offer discounts on bulk purchases of products. The service industry also offers special discounts on prepayments or advance subscriptions.
For example, many SAAS companies offer discounts on annual subscriptions as compared to their monthly plans.
Thus, these sellers receive prepayments for products or services that would be delivered in the future. In most cases, the seller provides these products/services gradually for a specified period.
If the seller follows cash accounting, then there is no need to record the unearned or deferred revenue. Cash accounting does not support accruals and deferrals. It records a transaction on a cash basis as and when the transaction is completed.
If the seller follows accrual accounting, then the transaction must be recorded immediately. Accrual accounting also follows the matching principle. Therefore, the seller must record two entries to record the prepayments.
The seller will record the current liability and label it as deferred revenue. As the seller fulfills its obligation, it shifts this amount from the balance to the income statement.
It simply means that a liability converts to income when the seller fulfills its commitment to the buyer.
Any product returns or after-sale service costs are adjusted as normally the sellers do.
Is Deferred Revenue a Liability and Why?
Yes, the deferred or unearned revenue is a liability. It should be recorded under the current liability section of the balance sheet.
So, why is deferred revenue a liability?
Sellers have an Obligation
Deferred revenue should be treated as a liability because the seller has an obligation toward the buyer. The seller is yet to provide the products or services as promised.
It means a seller cannot show these advance payments as earned income.
The prepayments do not mean guaranteed sales. Buyers can cancel the transactions at any time.
Also, the rates or cost of the transaction can change over time. Therefore, uncertainty exists until the transaction is completed. Uncertain and unconfirmed transactions cannot be recorded as confirmed or earned revenue.
It Prevents Overvaluation
If businesses are allowed to record deferred revenue as income, they can easily be overvalued. It would lead to accounting misrepresentation as well.
It will also lure accountants to manipulate accounting books to show favorable but window-dressed account books.
Overvaluation is a common concern for businesses with intangible assets. Particularly, in the service industry, analysts are skeptical about overvalued assets like goodwill and patent valuations.
Compliance with GAAP Rules
Accrual accounting and GAAP rules state a transaction must be recorded as and when it happens. Regardless of when the cash is paid or when the transaction is completed.
Therefore, recognizing prepayments as unearned revenue follows GAAP rules. The seller can record it on the balance sheet until the revenue is recognized.
Journal Entry for Deferred Revenue
Once both parties agree on a sale transaction and the customer makes an advance payment, the seller can record it as a deferred liability in its account books.
The journal entry to record an initial deferred revenue transaction will be:
|Deferred Revenue||$ XXXX|
The seller may provide services over time gradually. Therefore, the recognition of deferred revenue into income can be done partially as well.
The journal entry to record the revenue against deferred revenue will be:
|Deferred Revenue||$ XXXX|
|Revenue Account||$ XXXX|
If the services or products are delivered at once, there will be only one reversal entry to record the revenue.
Suppose ABC company is working as a SAAS company that provides bookkeeping services to its customers. It offers different monthly and yearly subscription plans depending on the service type and size.
One of its customers subscribes to its annual plan of $ 3,600 which would otherwise cost $ 350 per month. The customer must pay the full amount of the yearly subscription plan to avail the discounted price of $ 3,600.
The journal entry to record the initial transaction for ABC company will be:
|Deferred Revenue||$ 3,600|
Since ABC company will provide monthly services, it will record revenue on a monthly basis.
Each month ABC company will record the following transaction:
|Deferred Revenue||$ 300|
|Annual Subscriptions||$ 300|
After twelve months, the deferred revenue recorded as a liability of $3,600 will be converted into a revenue of $3,600 on its income statement.
Deferred Revenue in Accrual Accounting
The Generally Accepted Accounting Principles (GAAP) provide comprehensive guidelines on revenue recognition.
Accrual accounting guides that a business must record revenue when it is recognized. It also guides that a transaction must be recorded as and when it occurs rather than when cash is received.
Therefore, businesses must fulfill both of these conditions when they receive prepayments from customers. Recording prepayments as deferred or unearned revenue on the balance until the transaction completes fulfills both these objectives.
The GAAP rules also encourage businesses to follow accounting conservatism. It states that a business must record the least-possible profit amount when faced with uncertainty.
Unearned revenue also faces uncertainty as discussed above. Therefore, recognizing it as a short-term liability fulfills this accounting objective as well.
If a business records unearned revenue as fully recognized income, it is considered aggressive accounting. It leads to the overvaluation of a business. Thus, recording unearned revenue as a liability complies with the principles of revenue recognition.
Deferred Revenue Vs Unearned Revenue
Both these terms are the same. In accounting terms, unearned revenue is the income that a business has not earned.
Deferred revenue is also the income that a business will earn in the future. Both types of revenues are anticipated income as committed by customers.
The accounting recognition and reversal entries for both these revenues are also the same.
In short, unearned and deferred revenues are used interchangeably but are effectively the same concepts.
Deferred Revenue Vs Accrued Expense
Accrued expenses are the payments that a business makes in advance against services/products received.
Accrued expenses are the opposite of prepaid expenses as the business makes payments after receiving goods or services from the seller.
Accrued expenses also follow the same principles of accrual accounting. A business would record accrued expenses as current liabilities when the transactions incur. The business will record it in the balance sheet as a short-term liability rather than an expense on the income statement.
Once the buyer makes payments to the seller, the accrued liability will be reversed from the balance sheet and taken to the income statement. It will also gradually decrease the cash amount as and when the payment is made to the seller.
Both deferred revenue and accrued expenses follow the same accounting principles of receiving and paying in advance.
Deferred Revenue FAQs:
Why it is considered a liability?
It is considered a liability because the seller owes an obligation of delivering goods or services to the buyer.
Is it the same as unearned revenue?
Yes, unearned revenue and deferred revenue represent the same thing in accounting terms. Both terms are used interchangeably.
Why does not cash account record deferred revenue?
Cash accounting recognizes a transaction when cash is exchanged. Therefore, deferred revenue does not exist in a cash accounting system. It is only used by businesses following accrual accounting.
Which type of businesses use deferred revenue?
All types of businesses can use deferred revenue. However, it is mostly used by service businesses that receive prepayments and provide services over the contract period.