We come into contact with deferred revenue more often than you think. If you have ever subscribed to get a year’s supply of magazines at $24, the company earns a deferred payment of $2 for each month it delivers a magazine to you. The same applies when you go to the theatre and pay a discounted rate for a season ticket.
You pay for a series of plays in advance with the hope that your local theatre company stages good productions and doesn’t cancel. The money you spend goes into deferred revenue until they start putting on shows.
Still can’t get the gist of it? Do not worry. In this post, we’ll go through the concept of deferred revenue, how it works, and how to ensure that your company’s deferred revenue accounting is as tax-efficient as possible. And first of all, we need to have a clear understanding on deferred revenue meaning.
What Is Deferred Revenue?
Due to the nature of business, inlets of revenue may vary substantially. But what is deferred revenue? In accounting, deferred revenue is incurred when customers make a payment for future products or services. Because the money has not yet been earned, the seller registers it as a liability. It is also referred to as prepaid expenses or accrued expenses.
Typically, any money received by a business is considered an asset. However, when you get an upfront fee, it is recorded as a liability on the balance sheet as deferred revenue. This is because there is still a chance that the seller may not provide the goods or service or that the buyer will cancel the transaction.
Deferred revenue is recorded because you technically owe the customer the promised good or service.
Why Do Companies Record Deferred Revenue?
All businesses, but particularly those that are just getting started, must keep precise financial records. Probably the biggest reason companies behind deferred revenue accounting is because it helps create a visual of the profit and loss margin in real-time. This not only makes budgeting a lot easier, but it is necessary for tax purposes.
Many enterprises are at high risk of falling into bankruptcy if they fail to keep track of their financial records. It helps companies correctly forecast income and conduct business because it allows for careful tracking of generated income. But until it is earned, it’s deferred revenue.
As soon as your organization has a legal right to collect payment from a client, any revenue that is deemed earned is viable for tax reporting. If your company sells commodities, the date of shipping or when a buyer acknowledges delivery may well be the signal for revenue recognition.
For service-oriented businesses, taxable revenue may be earned when the services are provided or feasibly on a future date when associated deliverables are concluded.
How Does Deferred Revenue Work?
Consider this scenario: You run a cake store. For a 12-month cake subscription, a customer pays you $210. You, thus, make a deferred revenue definition in the journal entry. Because the amount of cash in your business has increased, you will debit the money to your cash account when you receive it. The journal entry will look something like this:
Since the sum of deferred income is increasing, you will credit your deferred revenue account. But your client still expects a year’s worth of cake deliveries. As a result, you decide to recognize $20 of the deferred revenue each month for the next 12 months. For instance, in the first month of delivery, you’ll make the following entry:
The company can only consider the upfront payment as earned after fulfilling its responsibility in delivering owed products or services. In short, this entry decreases the liability account and increases revenue.
What if You’re Making the Payment?
The idea follows the same premise, only in reverse. Deferred expenses are reflected on the balance sheet as an asset until the costs are catered same as deferred revenues. The asset depreciates as expenses are incurred, and the expenditure is reflected on the income statement.
Consider the following example of a journal entry for six months of paid-in-advance dedicated web hosting services. Prepaid service (Asset account) increases in this transaction, whereas Cash (Asset account) is reducing. Your books should look like this:
The expense is recorded resembling the below entry whenever a month has elapsed: We are reducing Prepaid Hosting Service while increasing Hosting Service Expense on the revenue statement.
How to Make Your Deferred Revenue Accounting Audit-proof
Due to the nature of deferred revenue, it is somewhat easy for errors to find their way into your books. This has the potential to cause significant inconveniences and even losses in the future. To avoid such problems with your account:
- Try to keep human errors at a minimum. Ensure the accountant you employ or hire is skilled. They must be conversant with accrual accounting and know what account is deferred revenue. Highly-skilled personnel are more likely to recognize and fix mistakes.
- Automate your processes. An excellent solution is using AI-oriented solutions to help you manage thousands of lines in a spreadsheet and maintain compliance with standards.
In case of forfeiture, the business is required to compensate the client adequately. But to avoid such scenarios, service and payment terms are stipulated in a legally-binding contract signed by both the seller and buyer.
Most parties prefer contract provisions that state that the selling entity may not recognize revenue until all items and services have been delivered. This, in turn, might cause a company’s reported performance to be skewed, with early losses followed by profits in future quarters.
Example of Deferred Revenue
Deferred revenue is popular among software and insurance companies, which often demand upfront payments in exchange for long-term service terms. The same applies when you order magazines or make a reservation, money is paid before the service is provided.
Typically, all SaaS and subscription-based services incur this type of revenue. Whether it’s the daily paper, weekly magazine, monthly wifi services, or yearly insurance premiums. You can also see in everyday life— even when it’s not so apparent, like paying for a year of Netflix upfront or weekly payment to a catering company for delivery of lunch to your employees. These are all good examples of how to define deferred revenue in regular transactions.
Although recording deferred revenue isn’t so great for matching income and expenses, it makes accounting easier. Assessing and redeeming deferred revenue calls for patience. It is ill-advised to start spending cash received as deferred funds to recover from that recent slump.
Do not invest as-yet unearned money to maintain a balanced picture of your company’s position and growth potential.