Introduction of Deferred Revenue
Deferred revenue is defined as the payments which are received in advance for products or services that have not been delivered or rendered yet. The revenue generated from these advance payments is classified as a liability rather than assets on a balance sheet.
Explanation
When a customer has already made the payment for a service or product and the service is yet to be rendered, or the product is yet to be delivered, the payment received in advance will be considered as Deferred Revenue. There is a possibility that the firm may not be able to provide the required goods or services in a prescribed time; hence the advance payment received from the customer is recognized under the liability section of the balance sheet.
How does it Work?
Deferred revenue is an advance payment that a firm receives for the services or products it will deliver in the future. It is recorded under the liabilities account on a balance sheet. As the payment is received in advance, the firm has an obligation toward the customer to deliver the required goods or services.
There is a possibility that the firm may not be able to deliver the required goods or services in a prescribed time; hence the advance payment received from the customer is recognized as a liability. There could also be a possibility that the customer may cancel the order; in such a case, the firm will have to repay the customer, as per the signed agreement.
Agreements made between customers and firms can specify different terms and conditions. The contract can also be such that no revenue will be recorded unless all the services have been rendered. In this case, the payment received from the buyer will be kept in deferred revenue until the product or services have been delivered to the customer, as mentioned in the contract. It is recorded as a current liability on the firm’s balance sheet, as prepayment terms are majorly for 12 months or less.
However, suppose the buyer made an up-front prepayment for services that need to be rendered over several years. In that case, the payment segment regarding the services or products that need to be generated post 12 months from the payment date must be recorded as deferred revenue under the long-term liability on the firm’s balance sheet.
Examples of Deferred Revenue
For example, ABC Inc receives a $3,600 payment in advance at the beginning of its fiscal year from a customer for an annual magazine subscription. Once payment is received, a debit entry is recorded to the cash and cash equivalent account, and a credit entry is registered to the deferred revenue account for $3,600.
Each month, ABC Inc supplies the magazine to its buyer and recognizes generated revenue. At the end of each month, a debit entry is recorded to the deferred revenue account, and a credit entry is registered to the sales revenue account for $300. The entire deferred revenue balance of $3,600 has been recorded as revenue on the firm’s income statement by the end of the fiscal year at $300 per month, leaving the balance as $0 in the deferred revenue account.
Types of Deferred Revenue
- Monthly advance rent received for property owned.
- Prepayment received for the subscription to a newspaper or magazine.
- Prepaid insurance.
- Prepaid software products.
- Prepayment received for hotel/room booking.
- Advance payment for providing loading/unloading or transport facilities.
Why is Deferred Revenue Considered Liability?
It is an advance payment that a firm receives for the services or products it will deliver. It is recorded under the liabilities account on the balance sheet. As the payment is received in advance, the firm has an obligation toward the customer to deliver the required goods or services.
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There is a possibility that the firm may not be able to deliver the required goods or services in a prescribed time; hence the advance payment received from a customer is recognized as a liability. There could also be a possibility that the customer may cancel the order; in such a case, the firm will have to repay the customer, as per the signed agreement.
Deferred Revenue Journal Entry
ABC Inc receives a $3,600 payment in advance on 01’April, 2019 from a customer for an annual magazine subscription. Once payment is received, a debit entry is recorded to the cash and cash equivalent account, and a credit entry is registered to the deferred revenue account for $3,600.
Each month, ABC Inc supplies the magazine to its buyer and recognizes generated revenue. At the end of each month, a debit entry is recorded to the deferred revenue account, and a credit entry is registered to the sales revenue account for $300.
| Date | Account | Notes | Debit | Credit |
| 1/4/2019 | Cash | Payment for Magazine subscription | 3600 | |
| Deferred revenue | 3600 |
| Date | Account | Notes | Debit | Credit |
| 1/5/2019 | Deferred revenue | One month of Magazine subscription | 300 | |
| Revenue | 300 |
Importance of Deferred Revenue
- It helps in accurately reporting assets and liabilities on a firm balance sheet. The company avoids recording the Income on assets which has not yet been earned by registering deferred revenue in liability. Hence, Deferred revenue can avoid overvaluing the firm’s net worth.
- The Income obtained in advance is helpful in financing operations, thus mitigating the pressure on other assets or firms that do not need to take a loan.
- It represents the firm’s overall financial health by revealing the amount that the company owes to the customers. Revenue that the firm obtains from the customer but is yet to earn is a risk unless the product or service is rendered.
Difference between Deferred Revenue and Accrued Expense
It is the payments received in advance for products or services that have not been delivered or rendered yet. Accrued expenses are expenses of a firm that have already been incurred but are yet to be paid.
Examples: When a customer has already paid for a service, and the service is yet to be delivered, the payment received in advance will be considered Deferred Revenue.
While a customer has purchased a product and hast to pay $3000, he has already mentioned that he will spend next month. The expenses incurred here will be considered accrued expenses.
Advantages of Deferred Revenue
Some of the advantages are given below:
- The firm will have revenue in advance, and the business needs to deliver the required goods or services and need not worry about payment default.
- The amount that a firm has received in advance can be utilized in financing operations.
- Deferred Income is accounted for in liabilities; deferred Income is the Income a firm has obtained but not yet earned. It will be earned once the required services are delivered; hence, unearned Income will not be recorded in assets.
- Knowing the amount in Deferred Revenue allows an investor to analyze the firm’s financial health while investing. One, the investor will be able to know that if the firm needs to provide services to the customer in the future, second high deferred revenue indicates that the firm already has no. of projects in the pipeline, which shows that the firm is running a good amount of business.
Conclusion
It is the payments received in advance for products or services that have not been delivered or rendered yet. There is a possibility that the firm may not be able to provide the required goods or services in a prescribed time; hence the advance payment received from a customer is recognized under the liability section of the balance sheet.
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