Deferred revenue appears to be an asset in some situations, yet it is always classified as a liability in accounting. Why is that, and what to know about this unconventional account? Find out all that and more in this article.
Deferred Revenue Simply Explained
Payment from a consumer that has not yet gotten a good or service is referred to as deferred revenue. The payment is not yet included in the revenue total. Due to the incomplete nature of the revenue recognition process in accrual accounting, deferred revenue, also known as unearned revenue, is recorded as a liability on the balance sheet.
- Deferred revenue is income collected in anticipation of future delivery of products or services.
- On a company's balance sheet, deferred revenue is reported as a short-term liability.
- On the balance sheet, money received for the upcoming good or service is shown as a debit to cash.
- As soon as revenues are realized, the liability account is decreased by the same amount, and the revenue account is raised on the income statement.
- While the cash method records income as it is received, the accrual accounting approach records revenue as it is completely generated.
Read our article to learn more about Accrual vs. Cash Basis Accounting.
Before Anything: What Is A Liability?
A liability is a financial debt of a corporation based on past business activity in accrual accounting. Liabilities are sometimes oversimplified as a company's future-payable debt.
Understanding liabilities is crucial for comprehending deferred revenue accounting. Liabilities are caused by various commercial circumstances, all of which are connected to instances in which a firm owes money to another entity.
Think about the following three circumstances:
- 1st scenario: A business utilizes power and receives a utility bill.
- 2nd scenario: A business takes out a loan to buy a warehouse.
- 3rd scenario: A client pays a firm, but the consumer hasn't yet received any items.
The corporation has conducted business in all three instances. Because of such commercial activities, the corporation now owes someone money (the company owes the lending institution a mortgage payment, the electric company a utility payment, and the customer the goods they paid for). In each of the three situations, the business now owes money.
Deferred Expenses vs. Deferred Revenue
Similar to deferred revenues, deferred costs include the payment for something to be recognized later. Deferred costs are funds used for commitments that have not yet been met, whereas deferred revenues are funds collected for goods or services that will be delivered to consumers later.
A deferred expense has been paid but has not yet been incurred. Deferred costs include things like rent payments. Rent is paid upfront for the use of land or property in the future.
The deferred expenditure is listed as an asset on the balance sheet of the business (e.g., prepaid rent). The prepaid expenditure falls under the asset category. The cash account receives a credit for the same amount while that account is debited.
When a cost is incurred, it is recorded on the income statement, and its associated asset is decreased on the balance sheet.
Deferred Revenue Example In Accounting
A golf club charges its members SAR 120 in annual dues, which are levied right away when a member registers to join the club. The services are not yet complete when the payment is received. The club would credit SAR 120 in deferred revenue and debit SAR 120 in cash.
Every member has "reached" the advantage of having used the club for one month at the end of the first month of membership. As a result, the golf club has met its obligation to provide golf club benefits for a complete year in one month (1/12th).
By crediting the sales account and debiting the deferred revenue account, the club would record SAR 10 in revenue. Up until the end of the year, when the deferred revenue account balance would be zero, the golf club would continue to recognize SAR 10 in revenue each month.
The entire SAR 120 would then be shown as revenue or sales on the yearly income statement.
Deferred Revenue Is A Liability, But Why?
Money received but not yet earned is referred to as deferred revenue. In other words, the products or services for which payment has been received will be provided at some time in the future. As a consequence, the client is owed what was purchased by the business, and payment can be returned before delivery. Hence, the deferred revenue is a liability until it is earned.
How Do Businesses Acquire Deferred Revenue?
When a business receives payment for a service it has not yet provided, it generates deferred revenue. This typically occurs for service providers that hold off on doing the project until at least a portion of it has been paid for. Deferred revenue is earned when a business performs its end of a contract after payment has been received.
Customer payments for products or services they anticipate receiving in the future are known as deferred revenues. The firm owes the client money until the service is rendered or the product is delivered, momentarily turning the income into a liability. Once generated, revenue is recognized and recorded as revenue rather than being postponed.
Want to find out more about revenue recognition, inventory management, and other vital accounting practices? Check out one of our related articles now—see you there!
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