Accurate accounting and bookkeeping are essential to SMEs like yours. Not only do you need to be assured that your tax affairs are in order, you also need to be able to get a clear snapshot of your business finances at any given time. This is the key to maintaining harmonious cash flow and being able to make capital investments without endangering your business finances.
But the waters are muddied when you accept payments in advance. This results in what is known as deferred income. Here we’ll look at what we mean by deferred income, and how to incorporate it into your accounting.
What is deferred income?
Deferred income is also known as deferred revenue or unearned income. As the name suggests, it refers to income that you have received or not earned yet. Usually, this is because a customer or client has made an advance payment for services that have not yet been rendered or goods that have not yet been delivered.
Deferred income can be useful in keeping a healthy space between your top and bottom line. However, it’s also very important to remember that it’s a liability, and needs to be accounted for as such. As soon as you start thinking of deferred income as liquid cash to spend, you become vulnerable to potential cash flow problems.
Key examples of deferred income
For many businesses such as retailers, deferred income isn’t really an issue. Goods are delivered and paid for almost simultaneously. However, there are lots of business models that rely on deferred income.
Some key examples include subscription services such as subscription boxes, streaming services or newspapers and magazines. Monthly insurance premiums are also a form of deferred income. If you are a solicitor or paralegal who is on a retainer, this also counts as a form of deferred income. Likewise, any time a creative service is engaged and a down payment made in advance, this must also be classed as deferred income.
How does deferred income work?
Deferred income needs to be properly accounted for if you’re to get a reliable overview of your finances. As tempting as it may be to think of the income as “yours”, it needs to be recorded as a liability. After all, if you are unable to deliver on your goods or services (or the client should cancel), you will be expected to have this revenue available to refund them.
Only when goods and services have been delivered can the income be considered an asset, and be committed in your balance sheet accordingly.
Your accounting entries for deferred income should look something like this:
First, post the sales invoice.
Next, ascertain how much needs to be allocated to each month, and defer the income accordingly from your P&L to your balance sheet. Spreading the amount evenly across two to three months can strike a balance between facilitating cash flow and keeping the payment liquid should it need to be refunded.
Write the income related to the following months back from your balance sheet to your P&L.
Tips for managing deferred income
Once you’ve got into the habit of properly accounting for deferred income, it’s easy to manage your cash flow and better understand your finances. However, here are some useful tips for managing deferred income:
Remember that income is deferred net of VAT (if you are registered for it). VAT is owed to HMRC from the tax point date of the invoice, and payable by your client.
Be sure to reconcile deferred income regularly to maintain healthy cash flow and get a clearer overview of your assets.
Auto-reverse deferred income at the beginning of every month to avoid forgotten accruals.
We can help
If you’re interested in finding out more about deferred income, advance payments, or any other aspect of your business finances, then get in touch with our financial experts. Find out how GoCardless can help you with ad hoc payments or recurring payments.