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. $500). Then, it would increase the accrued expense account.
Accrued expenses are different than accounts payable. For an expense to be recorded in accounts payable, you need to receive an invoice or request for payment. For accrued expenses, you haven’t received the invoice, and the final amount due may not have been determined yet.
How does deferred revenue work?
When a company receives funds to cover future work, it’s considered deferred revenue. This can include deposits or down payments. These funds are deferred revenue regardless of whether the company invoices the client.
The company will not record the money as revenue until services are performed or goods are delivered.
It’s important to review the deferred revenue account on a monthly basis. This ensures that you record all revenue for delivered work on the profit and loss statement.
Recording deposits as deferred revenue prevents companies from paying taxes on revenue that has not yet been earned. For example, if you offer a refundable deposit and a client cancels a project, you’ll have to return the funds. You don’t want to pay taxes on that deposit, since you had to return it.
How do you make a deferred revenue journal entry?
To record a deferred revenue journal entry, you first need to create a deferred revenue liability account. These accounts are generally current liabilities unless you expect the project to take several years. In that case, you would consider it a long-term liability.
To record the funds that you receive, the deferred journal entry debits the bank account. Then, it credits the liability account to show your obligation to provide future services.
|Cash in Bank||$X|
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
|Cash in Bank||$1,000|
3/1/2021: Collection of 50% of the purchase price when work starts (less initial deposit already received)
|Cash in Bank||$49,000|
8/31/2021: Collection of remaining balance and recognition of revenue on completion of the project
|Cash in Bank||$50,000|
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.
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.