Deferred revenue / deferred liability:
Deferred revenue, also known as “unearned” or deferred income, is any revenue we collect from our customers before earning it. So, if we have received money without earning it, it will be a liability. That’s why we pass following journal entries in the books of accounts.
|Cash in hand||Assets||XXX|
Given transaction reflects that deferred revenue is like receipt of the income. In other words, deferred revenue is a reimbursement from a customer for future goods or services.
The seller needs to account for this payment as a liability since it has not yet been earned. Deferred revenue is generally among software and insurance providers, who need up-front payments for service periods that may end for many months.
We record deferred revenue as a short-term or current liability on the balance sheet. Current liabilities are likely to be repaid within one year, unlike long-term liabilities that usually last longer.
Deferred revenue is a short-term liability account because it’s a debt. As the recipient/supplier earns revenue over the period, it reduces the balance in the deferred revenue account (with a debit). It increases the balance in the profits account (with a credit). It can be reflected in the following journal entry.
|Revenue||Profit n Loss||XXX|
The debit impact of this transaction is a decrease in the liability as the supplier has performed the services and earned revenue. Hence, the supplier needs to remove liability. On the other hand, credit impact reflects the recording of the revenue in the financial statement.
Depending on the contract terms, the selling entity may not be allowed to be familiar with revenue until all goods have been delivered and/or services performed; this can skew the reported presence of a business to show early losses, followed by profits in later periods.
The deferred revenue account is usually classified as a current liability on the balance sheet. It can be classified as a long-term liability if performance is not likely within the next twelve months.
Deferred revenue in cash accounting and accrual accounting:
There are two widely used accounting systems: cash accounting and accrual accounting. We need to opt for one depending on the size of our company, its ownership profile, and local regulatory requirements.
In cash accounting, revenue and expenses are documented when they are received and paid in the order. That shows there is no deferred revenue. Once the business is paid, the revenue is recorded in the income statement.
In accrual accounting, things are a lot more complex. Revenue is considered when it is earned and not when the cash is received. If we have earned revenue, but a client has not yet compensated their bill, then we report our earned revenue in the accounts receivable journal, which is an asset. On the other hand, if we have received cash from a client but have not yet earned it, we take unearned revenue in the deferred revenue journal, which is a liability.
Deferrals like deferred revenue are usually used in accounting to accurately record income and expenses.
It should be noted that deferral is an important tool in accrual accounting to handle profit/loss reporting. It’s used to make financial reporting logical and near to conceptual reality.
Why is deferred revenue classified as a liability or income?
To be precise, we cannot consider deferred revenues as income until we earn them; we deliver the products or services to earn revenue. Therefore, we cannot report these revenues on the income statement. We will report them on our balance sheet as a liability as a replacement.
Companies consider deferred revenue a liability account on their financial statements because a deferred revenue balance represents incoming cash. Still, it also shows an obligation to fulfill an order in the future. Upon pleasing the order, the company may regard it as the money to be earned revenue; until the point of fulfillment, the money is measured as unearned revenue.
In generally accepted accounting principles, companies are advised to report their income conventionally and avoid presenting a deferred revenue account as working capital on a balance sheet. And the same goes with the international financial reporting standards. So, cash received under deferred revenue should not be reflected as working capital balance.
Companies use the accrual accounting method to accurately depict how deferred income functions as a liability, not an asset, in a certain fiscal year. On the other hand, smaller companies that cannot staff an accounting department or pay a certified public accountant may use a cash-based accounting method that shows deferred revenue as net income.
Cash accounting may be appropriate for small companies not seeking outside investors. Still, companies may lift ethical concerns if they use the deferred income to increase an outside valuation. Just because we have received deferred revenue in our bank account does not mean our clients will not ask for repayment in the future if we do not perform services or deliver the product.
In addition, some industries have strict rules regarding treating deferred revenue. The simple description is that we owe our client services, as they have waged us for services we have not yet rendered. A liability is somewhat we owe, and even if we owe services, it is still something owed. For the reason that it’s technically money, you owe your customers.
Even though it has the word “revenue” in it, deferred revenue is a liability because it shows goods or services we owe to our customers. Remember, just because that money is in our bank account doesn’t mean our client will not ask us for a refund in the future. Some industries also have strict rules around what we can do with deferred revenue. It saves us from overvaluing our business. Deferred revenue is a liability, partly to make sure our financial records don’t overstate the value of our business.
We cannot take referred revenue as income until we perform services or deliver risk and rewards related to product. As per vital accounting principles, a business should not record income until it has earned it and should not record expenses until it has spent them. For these purposes, accountants use the expression deferral to downgrade to the act of delaying recognizing certain revenues (or even expenses) on our income statement over a particular period.
As a replacement, we will record them on balance sheet accounts as liabilities until we earn or use them. We will move them in portions from our balance sheet accounts to revenues (or expenses) on our income statement.
The timing of customers’ payments is likely unpredictable and volatile, so it’s cautious about paying no attention to the timing of cash payments and only be familiar with revenue when you earn it. Businesses and accountants record deferred revenue as a liability because it represents products and services we owe our customers.
Frequently asked questions
Why is deferred revenue not revenue?
Deferred revenue is not revenue because the business has not performed services yet against cash receipt. It’s like an advance that is received from the customers. However, if you use cash-based accounting, revenue can be recorded, but it’s not a logical approach.
Where do we report deferred revenue in the financial statement?
Deferred revenue is recorded in the balance sheet as a liability. Because the receipt of cash brings present obligation on the business, and it will be settled when the business performs the service or delivers the product.
Is deferred revenue current liability?
Deferred revenue can be current liability or non-current liability, depending on the terms with the customer. For instance, if services are to be performed in the next twelve months, it will be a current liability. On the other hand, if services are performed for more than twelve months, it will be a non-current liability.