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Recognising revenue before it’s been earned can give you an unrealistic view of your company’s financial health, which is why the concept of revenue recognition is so important for business owners to understand. A key part of this topic is the idea of deferred revenue. But what is deferred revenue in accounting and how does it apply to your business? Explore deferred revenue in greater depth with our simple guide.
What is deferred revenue?
Deferred revenue, which is sometimes referred to as unearned revenue, is a term used to describe advance payments that businesses receive for services or products that haven’t yet been delivered. The generally accepted accounting principles (GAAP) encourage conservative accounting conventions, meaning that businesses using GAAP record the lowest amount of profit possible and only recognize earned revenue when the likelihood of payment is a near certainty. Therefore, it’s vitally important for businesses to have a full grasp of deferred revenue in accounting so as to remain GAAP-compliant.
Is deferred revenue a liability?
Yes, deferred revenue should be categorised as a liability, rather than an asset, on your business’s balance sheet. This is because it describes revenue that hasn’t been earned, and therefore represents a product/service that is owed to the customer. If you’re running a subscription service and a customer decides to terminate their service, for example, you’ll need to return the revenue for the remaining period. So, even though this deferred revenue shows up in your business’s bank account, it can’t be counted as revenue just yet. It’s also important to note that in most cases, deferred revenue should be reported as a current liability, as prepayment terms tend to be for less than 12 months.
Examples of deferred revenue in accounting
To understand deferred revenue in a little more depth, let’s look at an example. Imagine that a landscaping company – Company A – has been asked to provide landscaping design services for a commercial property. Company A provides a quote for $20,000, splitting the fee up into $15,000 at the time that the contract is signed and $5,000 upon completion of the project. Company A estimates that the project will take around 50 days and agrees to begin work 5 days after they receive the down payment of $15,000.
So, if Company A receives the $15,000 on July 1 and begins work on July 6, they’ll record a debit of $15,000 to cash and a credit of $15,000 to deferred revenue. At this point, the balance sheet will show a current liability of $15,000. As of July 31, 50% of the project will be complete. This means that Company A will need to record an adjusting entry (dated July 31) debiting deferred revenue for $10,000 and crediting the income statement for $10,000. Therefore, the July 31 balance sheet will report deferred revenues of $5,000, which represent the remaining liability from the original down payment of $15,000.
Deferred revenue vs. accrued revenue
When you’re dealing with the financials of a small business or start-up, there are a few different types of revenue that you’ll need to get to grips with, two of which are accrued and deferred revenue. So, what’s the difference between them? When it comes to deferred revenue vs. accrued revenue, there couldn’t be any more differences, because they’re diametrically opposed to one another. Whereas deferred revenue refers to income that you’ve already received for goods/services that haven’t been delivered, accrued revenue refers to income that you haven’t received for goods/services that have already been delivered.
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