Deferred Revenue is an advance payment received by a person or company for services or goods that are to be delivered or performed in the future.
Deferred Revenue is also known by other names such as unearned revenue or unearned income, as the company or the person who receives it owes service or goods to the clients. Even though Deferred revenue is a kind of income for the company, the company recognizes deferred revenue as a liability.
Every business firm or company maintains a balance sheet which is a sheet that records the financial details of the company like its assets, debts, liabilities, etc. So while entering their balance sheet, a company enters deferred income as a liability.
Even though it is an income for the company’s goods or services, as the goods or service is yet to be received by the customer, deferred income is always seen as a liability on the balance sheet.
As the service for deferred revenue is yet to be delivered, this revenue cannot be added directly to the sales revenue of the company. Adding deferred revenue directly to sales revenue without delivering the service can lead to incorrect accounting if, by any chance, the company fails to deliver the promised service.
Also, if the customer is no longer interested in the service, that too can pose a problem while adding deferred revenue directly to the sales revenue. If any of the above situations arise, the company is expected to pay back the client unless there is an agreement between both parties stating otherwise.
Example Of Deferred Revenue
As mentioned above, Deferred revenue is an advance payment received by a company or person for a service or goods that they will receive in the future. One of the best examples of deferred revenue is magazine subscriptions.
Suppose you are a person who is opting for a magazine subscription, what is usually done is that the amount for a fixed period is paid upfront by the customer, in this case, you.
So when the company that distributes the magazine receives the payment from you upfront for a long period of time, that they do is that the amount received will be entered in their balance sheet as a liability. This is because the good you paid for, which is the magazine, is yet to be delivered to you.
As each magazine is delivered to you over time the company adds a certain amount of the magazine to their sales revenue and is done until the amount you paid runs out, which eventually will, stop your magazine subscription.
Just like the case of a magazine subscription, there are different events in our day-to-day life that e pay earlier and receive the service later, which can be seen as an example of Deferred revenue. Some of the other common examples for this case include;
- Tickets
Tickets are mostly sold in advance. So, the revenue received from selling the ticket is only actually earned after the event has taken place. Sometimes, tickets are even sold months before an event and until the event takes place, this revenue is considered deferral revenue.
- Paying Rent in Advance
It is a common practice to pay the rent of your room or house in advance to the owner. Here also the customer is making a payment for the service that they receive only in the future. The amount that is being paid in advance can depend upon the agreement between the tenant and the landlord.
- Online Shopping
Online shopping is a very common activity now and most of us pay the amount for the product online itself. Here too, e are making a payment for the goods that we are yet to receive.
It is only after the product is delivered that the amount e paid can be seen as an earning for the company.
Sometimes it might take days for the customer to receive the product while in some cases it might take only just an hour.
When Does Deferred Revenue Become Income Revenue?
A deferred revenue can only be considered as income revenue when the customer who pays for the service or goods receives it. Until it is received by the customer, deferred income is entered as a liability on the balance sheet of the company that’s offering the goods or services.
Deferred revenue is transferred to the income revenue account only after the service is delivered and the income is earned. This process is a very subjective one and it is entirely dependent on the type of business that is being discussed and also their modes of operation.
The criteria to consider deferred revenue as income revenue is usually based on the agreement that the company has with its customers.
Even though each company has a different type of operations method, one thing that every company must follow regardless of their other operations and criteria is Generally Accepted Accounting Principles (GAAP).
Why Is Deferred Revenue Considered A Liability?
As we mentioned earlier, Deferred revenue is recognized as a liability by the companies and not as an asset or income. Here are some of the few reasons why deferred income is seen as a liability.
- The money is not realized
Even though the customer has paid the money in exchange for a service, that service is yet to be delivered or fulfilled by the company. As a result, the amount cannot be shown as an income in the company account.
Also, there are chances that the customer might turn down the deal and opt out of it before the expected date of the delivery of the service or goods. In such cases, the customer should be repaid the money within a fixed time period according to the agreement or company policy.
- Prevents Over-Valuation of your Business
If the money received from a customer for any service that ill is delivered in the future, it cannot be added to the revenue account of the company. Adding amounts received in such regards to the company account has chances that create a ‘growth illusion.’
This will give you the wrong impression that the company is growing more than at an expected rate and it can also be confusing for your investors too.
- Multiple Services Offered
Some companies also offer additional services for their products along with the offered one like free maintenance for a product or any such kind.
So, the amount received will only account for the service that is provided, and the other will be deferred. So adding this amount along with the revenue of the company can lead to false positives in the cash-flow statements.
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Why Should Companies Record Deferred Revenue?
The simple answer to this question is that companies are required to record their deferred income. Even though the service for the amount has not yet been delivered and the amount cannot be included in the company’s income revenue.
Companies are required to record their deferred income due to the accounting principles of revenue recognition. In accrual accounting, the deferred incomes are considered liabilities as the customer has already made the payment and the company is expected to provide them with the service or goods in the future.
What Is The Difference Between Deferred Revenue And Accrued Expense?
Deferred revenue refers to the income received by a firm for their service or goods which is expected to be delivered to the customer in the future.
As the revenue received cannot be seen as income until the goods or service is delivered, deferred revenue is entered as a liability in the company’s balance sheet.
Oftentimes, deferred revenue or deferred income is mistaken for another similar situation which is known as an Accrued expense.
While deferred revenue talks about income, Accrued expense talks about expense and spending. Sp, accrued expense refers to the expenses that are recognized and entered in the books before the company of the firm makes that expense.
As per the expense recognition principle of accrual accounting, an expense from the part of the company should be recorded in the period during which they are incurred. It should be noted that these expenses are not recorded at the time of their payment.
Here Are A Few Examples To Understand The Case Of Accrued Expenses Even Better
- The supply of commodities by a utility provider like electricity or gas to their customers even though they have not received their bill yet.
- Here, even though the customer has not received their bill and has not made the payment, the service provider offers them commodities which can be seen as an expense for the company as payment has not been done.
- The preparation of a customer’s tax return by an accountant can also be seen as an example of the case as the accountant does the job without raising an invoice or receiving any kind of payment.
- An artist submitting an art piece from their creation for an agreed price. The client approves of the submitted work but the designer is yet to receive a payment.
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