Deferred revenue or unearned revenue is one of the main ideas in the field of accounting to that refers to the payments that a company gets from its customers before the company delivers the products or services. In essence, it is a debt or a liability that is recorded on the company’s balance sheet. Here, with this article, we understand the idea of deferred revenue in accounting and its operation. Also, we explain the accounting principle that is associated with deferred revenue. So, walk through this significant information guide for a better understanding of deferred revenue.
What is Deferred Revenue in Accounting?
Deferred revenue is refers to funds that a business gets before offering products or services to a customer. This amount is shown as a liability on the company’s balance sheet since the business is still bound to deliver the goods or services and hasn’t earned the revenue yet. As the company delivers its promise over time, the deferred revenue is gradually recognized as earned income on the income statement. And it is also known as unearned revenue.
How Deferred Revenue Works ?
In accrual accounting, Deferred revenue in accounting recognized when it is earned, not when it is received. Understand the deferred revenue works.
- When a customer pays money in advance for products or services, such as a one-year subscription or a deferred revenue gift cards, the company receives money. But the Company has not yet earned this money because it has not completed its part of the deal.
- The Payment is recorded as deferred revenue liability in the company’s balance sheet. That means liability represents the company’s obligation to its customers.
- For example, if a customer pays $1,200 for a one-year accounting software license, the cash increases, and a $1,200 liability called “deferred revenue” is created
- If the Company fulfil its responsibility, such as providing a service or product. So the part of deferred revenue moves from the liability account to the revenue account.
- At the end, this process will continue until the entire amount is earned and recognized as revenue.
Deferred Revenue Example
Break down the deferred revenue in accounting with examples and understand the deferred revenue with the help of examples
- Subscription-based Services: For a company such as Netflix or Microsoft Office 365, which is paid for a one-year subscription, the income is recognized monthly. In the case of an annual subscription payment income, the company recognizes the revenue month by month (i.e., 1/12th of the total per month).
- Prepaid Goods or Services: In the event that you buy an annual gym membership or prepay for a hotel stay, the business will recognize the revenue when you go to the gym or check into the hotel, rather than at the time of payment.
- Long-term Contracts: A company’s revenue from a long-term consulting contract is deferred until the service is delivered over the period of the contract. Although the payments are made upfront, the revenue is recognized as the work is carried out.
Why Deferred Revenue is a Liability?
Deferred revenue is a liability because the company has received payment but has not yet delivered the goods or services. And creating an obligation to the customer. Essentially, it’s a prepayment from customers, which means the company owes the customer the goods or services in the future.
- Responsibility to deliver: When a company receives a payment in advance from a customer, it has a responsibility to deliver the product or service in the future. It cannot recognize the revenue as earned. Until the company does not fulfills that responsibility company owes something to the customer, which makes it a liability on the balance sheet.
- Unearned Revenue: Deferred revenue is not considered earned revenue because the company doesn’t meet the criteria for revenue recognition. The company hasn’t completed the transaction, so it is considered a liability until the revenue is recognized over time or when the product or service is delivered.
- For Example: if you pay for an annual subscription to a software service, and the company does not recognize the full payment as revenue right away. They record it as deferred revenue(a liability) and then recognize a portion of it as revenue each month as the service is provided.
What is the Deferred Revenue Journal Entry?
The Deferred Revenue Journal Entry helps to record the transactions that businesses received in advance for goods or services that have yet to be made. When a company receives money in advance, it debits cash and credits deferred revenue. That refers to the liability account on the balance sheet. Rather than immediately recognizing the revenue as income, businesses treat it as a liability until the product or service is provided to the customer.
Journal Entry for Deferred Revenue
When a business receives payment in advance, it records a deferred revenue liability on its balance sheet. Now focus on the journal entry for deferred revenue.
Initial Payment Received (Cash/Revenue):
There are two options: the first is Debit Cash for an increase in assets, and the second is Credit Deferred Revenue for an increase in liabilities
Revenue Recognition (Service/Product Delivered):
There are also two revenue streams first one is Debit Deferred Revenue for Decrease in liabilities, and the second one is Credit Revenue for Recognizing income earned.
Deferred Revenue Journal Entry Examples
Understanding deferred revenue journal entry with the help of an example
Scenario: A software company sells its product with a 12-month subscription for $1,800.
- Entry: Debit Cash, Credit Deferred Revenue
- Debit: Cash $1800
- Credit: Deferred revenue $1800
If the service is delivered over the next 12 months, each month the company recognizes $300 as earned revenue
- Entry: Debit Deferred Revenue, Credit Revenue
- Debit: Deferred revenue $300
- Credit: Revenue $300
Which Accounting Principles are Involved in Deferred Revenue?
Break down the deferred revenue in accounting principles that are involved in deferred revenue.
Accrual Basis of Accounting
Accrual accounting is the fundamental principle of deferred revenue that helps to record when it earned. Other wise when the cash is received. In deferred revenue, the money received is recorded as a liability until the time the service or product is delivered.
Revenue Recognition Principle
The company can only recognize revenue when it delivers on its promise. Therefore, if a customer makes an advance payment, the company is not entitled to book the amount as revenue until the goods or services have been delivered.
Matching Principle
This principle ensures that the costs of goods sold or services provided are matched with the revenue recognized. In the case of deferred revenue, the expenses relating to the provision of the service are recognized together with the revenue as it is gradually earned.
Liabilities (Obligations)
Deferred revenue is recorded as a liability account since the business is yet to provide the product or deliver the service to the customer. It is only converted into revenue from the moment the obligation is met.
Conclusion
Deferred Revenue in accounting is a straightforward process for referring a payment to the company to receive before delivering the good or service to the customer. Deferred revenue involves accrual accounting, the recognition principle, and the match principle. And yes, deferred revenue is a liability, and it also creates a journal entry for debit cash and credit deferred revenue. This guide is really informative for understanding deferred revenue.