Advance payments a business receives for goods or services that will be supplied or performed in the future are referred to as deferred revenue, or unearned income.
The prepayment is recorded as deferred revenue, a liability on the balance sheet of the business that receives it.
Because it includes unearned money as well as goods or services owing to a client, deferred revenue is a liability. As the product or service is provided, it is gradually and proportionately recorded on the revenue statement.
Unearned revenue is another term for this. Postponed Revenue is the amount of money a business makes before the items and/or services for which it was paid are delivered or completed.
Revenue is not recorded in accrual accounting until it is earned. When a consumer pays in advance for goods or services, the business reports a liability on its balance sheet rather than revenue on its income statement.
Key Takeaways
- Customers who prepay for goods or services that have not yet been provided result in a liability on a business’s balance sheet known as deferred revenue.
- When the product or service is provided to the client, earned revenue is shown on the income statement. In order to adhere to the accounting conservative principle, GAAP permits the use of the deferred revenue account.
- Depending on the type, if the anticipated service or commodity was not provided, the business owes the consumer a certain amount of money.
Example of Deferred Revenue
A new customer paid Cloud Storage Co. $1,200 on August 1 for a one-year contract. Given that the services must be provided equitably over the course of a year, the business must collect $100 in revenue each month.
The business would report $0 in revenue on the income statement on August 1. Cash would rise by $1,200 on the balance sheet, and a $1,200 obligation known as deferred revenue would be formed.
The business would report $100 in revenue on the income statement on August 31. Cash would remain unchanged on the balance sheet, and the deferred revenue liability would drop by $100.
Until the end of the year, when the total revenue recognized during the period is $1,200, retained earnings are $1,200, and cash is $1,200, the pattern of recognizing $100 in revenue would recur every month. The transaction’s deferred revenue is now zero at that point.
How Deferred Revenue Works?
When a business receives an advance payment, it records deferred revenue as a liability on its balance sheet because it owes the customer the goods or services that are due.
Due to the possibility that the buyer may cancel the order or that the good or service may not be provided, the payment represents a liability to the company.
Unless otherwise agreed in a signed contract, the business would pay the customer back in any event.
Note
Contracts may include clauses stating that no money can be collected until all of the goods or services have been provided.
Until the customer has fully received what was owed under the terms of the contract, the money collected from them will remain in deferred revenue.
The corporation will report the lowest feasible profit because generally accepted accounting principles dictate certain accounting practices and conventions that support accounting conservatism.
Only until specific duties have been finished to fully claim the money and the likelihood of receiving it is nearly certain can a conservatively stated revenue be acknowledged.
To the extent that money is “earned” as a business provides goods or services, deferred revenue is frequently shown on the income statement over time.
Since prepayment terms are often 12 months or less, deferred revenue is typically shown on a company’s balance sheet as a current obligation.
In the event that a customer prepays at the front end for services for which the provider is to provide services spread over several years, the portion of the payment pertaining to goods or services to be provided after a lapse of 12 months from the payment date should be charged under the heading of deferred revenue of long-term liabilities.
Example of Deferred Revenue
Because subscription-based products and services usually need prepayments, deferred revenue has become a phenomenon. Prepaid insurance, yearly prepayments for software use, prepayments for newspaper subscriptions, and rent collected in advance are more examples of unearned revenue.
As a yearly payment for premium memberships for services like Amazon Prime, Zoom, Adobe, Google Suite Services, and AI-based services, this type of revenue has gained popularity.
All of them fall under the category of advanced payment, and the corporations promote this by offering a discount for yearly membership payments as opposed to monthly ones.
The advanced cash outlay made by the other business party in the prepayment would be listed on its balance sheet as an asset account or prepaid expense.
Over time, the other firm records the amount of the prepayment as an expense at the same rate as the first company records earned revenue.
When a consumer purchases a year subscription to a newspaper, the media firm receives a $1,200 advance payment at the beginning of its fiscal year.
Upon receiving the payment, the accountant for the company credits the deferred revenue account with $1,200 and debits the cash and cash equivalent account.
The business routinely sends the newspaper to its clients each month and keeps track of its earnings throughout the fiscal year.
Every month, the account will show a $100 credit to sales income and a debit to deferred revenue.
On the income statement, the entire $1,200 deferred revenue amount has been progressively recorded as revenue at a rate of $100.
FAQ’s
How is deferred revenue recorded?
It is recorded as a liability on the balance sheet under “Current Liabilities” or “Non-Current Liabilities,” depending on when the obligation will be settled.
When is deferred revenue recognized as revenue?
Revenue is recognized incrementally as the goods or services are delivered or performed.
What is the journal entry for deferred revenue?
When payment is received:
Debit: Cash
Credit: Deferred Revenue
When revenue is earned:
Debit: Deferred Revenue
Credit: Revenue
Common examples of deferred revenue include?
Subscription services, such as Netflix or magazines
Advance payments for software licenses or annual maintenance
Prepaid memberships or gym fees
Event tickets purchased well in advance
How is deferred revenue applied to subscription-based businesses?
Advance subscription payments are recorded as deferred revenue and are then recognized over the subscription as services are delivered.
How does deferred revenue impact the balance sheet?
Deferred revenue is a liability, and hence, it reduces the equity of the company until it is earned and recognized as revenue.
What happens to the income statement?
Deferred revenue does not appear on the income statement until the goods or services are delivered, at which point it is recognized as earned revenue.
Does deferred revenue affect cash flow?
Yes, it increases cash inflow when payment is received, but it does not directly affect net income until recognized as revenue. What is current deferred revenue?
Deferred revenue expected to be earned within one year is classified as a current liability.
What is non-current deferred revenue?
Deferred revenue expected to be earned beyond one year is classified as a non-current liability.
Can deferred revenue be both current and non-current?
Yes, if the contract covers a number of years, then all that was earned within the year is current and the rest non-current.