As a business owner, you may have heard the term deferred revenue before. But, what is deferred revenue and what does it mean for your business accounting? 

Deferred revenue is money that you receive from clients or customers for products or services that you haven’t delivered yet. In accounting, deferred revenue can affect your balance sheet and profit and loss statement. 

You need to understand how to recognize your revenue and record it on the profit and loss statement to do accounting properly. We’ll take a closer look at deferred revenue and what you need to know for your bookkeeping and accounting. 

What is deferred revenue?

As mentioned, deferred revenue is money that a company has received but hasn’t earned yet. This usually happens when a company sells a product or service but does not deliver it until a later date. Deferred revenue only applies to businesses that use accrual basis accounting.

An example of deferred revenue is if a customer buys a one-year magazine subscription. The company will recognize the revenue over the course of the year rather than when the customer pays. 

Recognizing revenue gradually helps companies match their expenses to the revenue they are actually earning. This provides a more accurate picture of your financial health and performance. 

Deferred revenue can also be used as an accounting tool to smooth out bumps in income or expenses. By deferring some revenue, a company can even out its cash flow and make its financials look steadier and more predictable. 

However, deferred revenue can also create problems if it is not managed carefully. If you overdo it, you may misrepresent your earnings and violate accounting rules. 

For this reason, companies need to exercise caution when recognizing deferred revenue. Make sure that you manage it transparently and stay compliant with accounting standards.

When do you use deferred revenue?

Companies that use cash basis accounting do not have deferred revenue. In cash basis accounting, a company considers the money it receives as revenue when it receives it.

Deferred revenue applies to companies that use accrual basis accounting. This method accounts for revenue when a company performs the services. 

Is deferred revenue an asset or liability?

In accounting terms, deferred revenue is classified as a liability because it represents a future obligation. When goods or services are delivered, deferred revenue becomes revenue. 

Deferred revenue increases your company’s short-term liabilities. It may also be taken into account when you apply for loans. It’s important for a company to understand its future obligations and ensure that it has funds to provide the services or products. 

Deferred revenue vs. accrued expenses

On the other hand, accrued expenses are expenses that a company records before they’ve made a payment.

Like deferred revenue, accrued expenses only apply to companies that use accrual basis accounting. Cash basis companies don’t record expenses until they pay the vendor.

For example, let’s say a company hires a cleaning service to clean its offices monthly. The cleaning company does not bill the client until the year is completed. The company should still recognize the monthly expenses for the cleaning services. 

In the example above, the company would record a cleaning expense each month (i.e. $500). Then, it would increase the accrued expense account.

Accrued expenses are different than accounts payable. For an expense to be recorded in accounts payable, you need to receive an invoice or request for payment. For accrued expenses, you haven’t received the invoice, and the final amount due may not have been determined yet. 

How does deferred revenue work?

When a company receives funds to cover future work, it’s considered deferred revenue. This can include deposits or down payments. These funds are deferred revenue regardless of whether the company invoices the client.

The company will not record the money as revenue until services are performed or goods are delivered.

It’s important to review the deferred revenue account on a monthly basis. This ensures that you record all revenue for delivered work on the profit and loss statement. 

Recording deposits as deferred revenue prevents companies from paying taxes on revenue that has not yet been earned. For example, if you offer a refundable deposit and a client cancels a project, you’ll have to return the funds. You don’t want to pay taxes on that deposit, since you had to return it. 

How do you make a deferred revenue journal entry?

To record a deferred revenue journal entry, you first need to create a deferred revenue liability account. These accounts are generally current liabilities unless you expect the project to take several years. In that case, you would consider it a long-term liability.

To record the funds that you receive, the deferred journal entry debits the bank account. Then, it credits the liability account to show your obligation to provide future services.

If you invoice a customer for future services, the journal entry would debit accounts receivable instead of cash in the bank.

Note that neither of the entries above will affect the profit and loss statement. The initial recording of deferred revenue only affects the balance sheet.

When a company fulfills its obligation by providing goods or services, it recognizes the revenue. When this happens, it reduces the deferred revenue amount and increases the company’s revenue.

Deferred revenue example

Consider a pool company that installs backyard pools. The projects typically cost $100,000, and the company collects an initial deposit of $1,000 to start scheduling the work. Once the work has started, the company collects an additional 50% of the purchase price. The final payment is collected when the pool is fully permitted by the city. 

In this example, the company would record the following journal entries for deferred revenue. 

1/1/2021: Initial Deposit for Jones’ pool

3/1/2021: Collection of 50% of the purchase price when work starts (less initial deposit already received)

8/31/2021: Collection of remaining balance and recognition of revenue on completion of the project

Note that the last entry above is the first time that it affects the profit and loss statement. 

Though, when you record the final entry, you should also record an entry to adjust the inventory or other expenses associated with the project. This will ensure that the revenue and expenses are accurately matched up on the company’s profit and loss statement.

The initial receipt of deferred revenue is straightforward since you’ve received revenue you have not earned yet. Determining when the revenue has been earned can be trickier and should be done with caution.

Understanding deferred revenue is important to maintain accurate books with accrual basis accounting. Companies need to understand their obligation to customers to ensure that they have the funds available to meet their obligations. 

However, you don’t have to manage all the ins and outs of accounting or deferred revenue on your own. Bringing in a professional can free up your time and help you get organized books all year round. 

Start in minutes

Bookkeeping? Taxes? CFO services?

Our bookkeeping and accounting experts keep your books clean, organized, and on time, every time.

Talk to an accountant

Xendoo offers online bookkeeping, accounting, tax, and CFO services at a range of pricing plans. You can also schedule a free, no obligation 20-minute consultation with one of our accountants to learn more about Xendoo and how we can help you with all your business finance needs.

At some point, you may need to buy equipment, tools, and other assets for your business. Those assets tend to wear out after several years and lose their value. Luckily, businesses can write off those expenses if they know about depreciation and how to calculate it. 

The straight-line depreciation formula is the simplest and most common way to calculate depreciation. In this article, we’ll go over the basics of depreciation and show you how to calculate it with the straight-line depreciation formula. 

What Is Depreciation?

Depreciation is the decrease of an asset’s value over time. You need to know about depreciation for tax purposes and to make sure financial statements are accurate. Business owners and accountants can use it to write off the costs of certain assets. 

Depreciation is typically calculated using one of several methods. Most commonly, you’ll use the straight-line method or the declining balance method. 

Tax considerations, accounting principles, or other factors will determine which method you should use. 

What Is Straight-Line Depreciation?

Straight-line depreciation is more simple than the declining balance method.

The straight-line depreciation method spreads the cost evenly over the life of an asset. Each year, you expense the same percentage. 

For example, let’s say a company purchases a $1,000 machine. The machine has a five-year useful life. The useful life represents how many years an asset will last. It’s also an estimate. Under the straight-line method, the machine would depreciate by $200 per year. 

Then, you would report the depreciation expense on your company’s annual income statement for five years. 

Straight-Line Depreciation Formula – How To Calculate It

To calculate an asset’s value, you need to know the straight-line depreciation formula and how to apply it. The straight-line depreciation formula is: 

• Depreciation expense = (Asset cost – Residual value) / Useful life 

Asset cost stands for the price at the time of purchase. For example, a golf course buys a cart for $12,000. The asset cost is $12,000. 

The residual value is the asset’s estimated value by the time it reaches the end of its useful life. It is also sometimes called salvage value. 

The straight-line depreciation formula can be used for any type of asset. However, it is most commonly used for depreciating business assets. This can include: 

• Buildings
• Machinery
• Equipment
• Vehicles
• Furniture

You can use the formula to calculate your straight-line depreciation expense. It’s the amount that can be written off each year. 

Straight-Line Depreciation Example

Consider an equipment purchase for $15,000. It has a useful life of five years. You estimate that at the end of five years, the equipment will have no value. The depreciation each year would be $3,000 (($15,000 – $0) / 5). A depreciation chart would look like: 

Other Depreciation Methods

There are three main types of depreciation: straight-line, declining balance, and sum-of-the-years’ digits. We know that straight-line depreciation spreads the cost evenly over the life of the asset. 

Although the straight-line method makes it easier to calculate depreciation, it does not reflect the true value or usage of an asset over time. For example, after you purchase a vehicle, you typically use it the most during the first few years. However, it can still have value several years after.

Let’s look at other methods. 

Declining balance method

Declining balance depreciation considers that an asset will be used more often in the first few years, so it will lose value then. 

You can calculate the declining balance method by multiplying a fixed depreciation rate by the current book value (CBV). The CBV is the asset’s estimated value in that accounting period. 

If we look at the same example as above: 

Note that the declining balance method produces larger expenses in earlier years and smaller expenses in later years. There is also the double-declining balance method which uses twice the rate of depreciation (i.e. 40% in the example above).

You may use the declining balance method to depreciate assets that lose value and become obsolete quickly. For example, you might use it to calculate depreciation for computers since they have a shorter useful life. 

Sum-of-the-years

The sum-of-the-years’ digits method is more complex. It provides a more accelerated schedule of depreciation than straight-line or declining balance methods. 

You calculate the yearly deduction by multiplying a fraction (the sum of all digits used to represent time periods divided by time period) by the asset cost. Then, you minus any salvage value. 

In our earlier example, you would calculate Year 1’s deduction by taking 5 divided by 5+4+3+2+1 multiplied by $15,000. You’d calculate Year 2’s deduction by taking 4 divided by (5+4+3+2) 5+4+3+2+1. Then, you multiply by $15,000. As you can see, this approach gets confusing. In most cases, you won’t need to use the sum-of-the-years.

When Do You Use the Straight-Line Method?

You should use the straight-line formula to depreciate an asset that steadily loses value each year. Assets like real estate and large equipment often use straight-line depreciation. 

It’s simple to calculate. However, the downside is that it does not reflect the true cost of certain assets.

When you know what depreciation is and how to calculate it, you can recoup some costs for purchasing assets. Depreciation can also reduce the amount of taxes owed. Luckily, you don’t need to do all the bookkeeping and accounting to calculate depreciation. With Xendoo, you can get an experienced bookkeeper, accountant, tax professional, and CFO all in one place. View our plans to decide which option is right for your business. 

The process of 3-way matching in accounts payable protects your business against incorrect or fraudulent invoices. It mitigates risks in your company’s spending by making sure you don’t overpay for services or fall for counterfeit invoices.

It may sound like no one would fall for invoice fraud—when a scammer pretends to be a business partner or vendor and sends a company an invoice for services that they didn’t actually deliver. Usually, it is sent through a business email that might appear legitimate and requests that the recipient send payment through a wire transfer.

However, invoice fraud happens more often than you’d think and to some huge companies. A few years ago, Google and Facebook both fell for a fake invoice and paid over $123 million to a Lithuanian scammer. Now, tech giants can afford to go after the scammers in an attempt to recover their funds, which Google and Facebook did. But, most small businesses can’t do that and can face devastating losses when they lose funds to tricks like these. 

One way that you can protect your business from fraudulent or incorrect invoices is by 3-way matching in accounts payable. In this guide, you’ll find everything you need to know about 3-way matching and how to use it. 

What is 3-Way Matching?

Three-way matching is the process of verifying an invoice is legitimate and the amount is accurate by looking at three documents. 

• Purchase order (PO)
• Receiving report
• Supplier’s invoice

We’ll go into each of these in detail later, but all three documents are needed to do a 3-way match. 

A 3-way match verifies invoices by comparing documents to prove your business:

• Requested products or services in the invoice and it is legitimate
• Received the types and quantities of goods that the supplier agreed to in the invoice 

You implement 3-way matching in accounts payable before issuing payment. Although 3-way matching primarily focuses on eliminating fraudulent invoices, it can also save you money by revealing an unintentional human error in a supplier’s invoice. 

It can tell you the correct amount and type of products you ordered from a supplier and ensure you only pay for what you received. 

Three-way matching is also part of the procurement process—getting, or procuring, goods and services for your business.

What is the Difference Between 2-Way, 3-Way, and 4-Way Matching?

While 3-way matching is the most popular method, it’s not the only way to compare invoices with other related documents. Other methods include 2-way and 4-way matching. Let’s identify how they differ.

2-Way Matching

If you use 2-way matching, you’re only comparing two documents—the purchase order and the supplier’s invoice. This method may be less time-intensive than 3-way and 4-way matching, but it leaves room for costly errors. 

Suppose your business needs 150 products and sends a purchase order to supplier X for the required quantity. However, the supplier mistakenly delivers 145 products and sends an invoice to your business for 150 products. 

Since 2-way matching only compares your purchase order and the supplier’s invoice, you will overpay the supplier for 150 products when you received 145.

Because 3-way matching uses a receiving report, you only pay for what you agreed to. In the above example, you’d only pay for what you received—145 products.

4-Way Matching

The process of 4-way matching in accounts payable compares four documents.

• Purchase order
• Supplier’s invoice
• Receiving report
• Inspection information

The inspection information is a report that the company uses to determine whether or not to pay for goods after an inspection. It may have a particular product quantity—above or below what it ordered from a supplier—that it can accept.

Many companies don’t need 4-way matching because the fourth verification step (inspection report) is nearly always unnecessary to establish an invoice’s legitimacy and accuracy. However, some enterprises may choose a 4-way match to manage frequent and large purchases. 

How Does 3-Way Matching Work? 

The 3-way match system tells you if the supplier invoices you’re paying are accurate — either accidentally or on purpose. How does it work? 

First, you need the three documents mentioned above. Then follow the steps below to verify invoices before issuing payment. 

1. Purchase Order

You’ll first look at the purchase order for verification. As a best practice, your business should not buy anything without a purchase order prepared in advance and entered into your accounting records. 

Once counter-signed by the supplier, the purchase order is a legally binding document. It should specify:

• Names and quantities of items to be bought
• Price of items
• Delivery date

2. Receiving Report

Once you have a purchase order, you’ll create a receiving report. To create this, you’ll check all the supplies you received and add them to your inventory. Look at the quantity and types of items to make sure it matches the purchase order. 

The report should then be entered into your accounting software. If you have an accountant or accounts payable staff, they can do this for you. 

A typical receiving report includes:

• Date and time of delivery
• Purchase order number
• Name of vendor and/or shipping company
• Description of each item received
• Quantity of each item received
• Condition of items received (necessary for returning damaged goods)

3. Supplier Invoice

The bill sent by the vendor should match both the purchase order and receiving a report in item names, quantities, and prices. It is the responsibility of accounts payable to make sure these three documents match — and if they don’t, find out why not.

Discrepancies may be resolved by having the supplier issue a revised invoice, or in some cases a credit memo. 

PO vs. Non-PO Invoices

When implementing 3-way matching in accounts payable, you should only use (PO) invoices. Non-PO invoices are unsuitable for a few reasons. 

PO invoices have a purchase order attached to them. They have all the details in a purchase order as well as an order number. 

On the other hand, a non-PO invoice is when a company buys something without a purchase order. It is also called an expense invoice because it usually refers to expenses incurred. Examples of non-PO invoices are: 

• Employee travel or meal reimbursement
• Mileage reimbursement

Example of 3-Way Matching

To illustrate how a 3-way match works, here’s an example. 

Caffeinated, a coffee shop chain, wants to order 500 products priced at $6 each from supplier Y. The coffee shop sends a purchasing order (PO) to supplier Y. In this case, the total product cost will be $3,000. 

Once the supplier delivers the order, Caffeinated’s receiving staff checks and records the inventory to verify whether the delivery matches the purchasing order. 

One week after delivering the orders to Caffeinated, supplier Y sends an invoice for the delivered products. 

The accounts payable team cross-references three documents—purchasing order, the receiving report, and the supplier’s invoice. The team compares product quantity, cost per unit, and total costs in the three documents. 

Should there be any discrepancies, the 3-way matching process will find them. For instance, if the supplier’s invoice mistakenly indicated that 550 were delivered, yet only 500 were, Caffeinated wouldn’t pay for the mistake. The receiving report will show the right product quantity and that is what you’ll pay. 

Benefits and Drawbacks of 3-Way Matching 

The benefits of 3-way matching are obvious: the prevention of human error or fraud which could result in financial losses for your business.

On the drawback side, the process can be time-consuming for accounts payable. 

This could lead to delays in payment, resulting in late fees and disqualification for early payment discounts. Consider these accounting tips to make it more efficient:

• Use software that automates purchase orders and receiving reports, and integrates them with your accounts payable
• Don’t require a 3-way match for recurring or small-dollar invoices
• Allow accounts payable staff to approve invoices if the amounts on the purchase order and the invoice are within a few percentage points of matching

Some of these solutions may be beyond the budget of most small businesses, but not when you use Xendoo. 

Our accounting software gives you enterprise-level capabilities at an affordable monthly fee. It’s just one of the ways we relieve ecommerce and small business owners from the work and worries of bookkeeping and free their minds to focus on doing what they love. Get a free trial today or talk with a Xendoo accountant.