Updated July 6, 2023
Introduction to Deferred Revenue
Deferred revenue is the payments received in advance for products or services that have not been delivered or rendered yet. The revenue generated from these advance payments is classified as a liability rather than an asset on a balance sheet.
Explanation
The company considers the received payment Deferred Revenue when a customer pays in advance for a service or product that is yet to be rendered or delivered. Suppose there is a possibility that the firm may not be able to provide the required goods or services within the prescribed time. In that case, we recognize the advance payment received from the customer as a liability in the balance sheet.
How Does it Work?
A firm receives deferred revenue as an advance payment for the services or products it will deliver, and it records it under the liabilities account on a balance sheet. The firm has an obligation toward the customer to deliver the required goods or services since it has received the payment in advance.
The firm may not be able to deliver the required goods or services in a prescribed time, so it recognizes the advance payment received from the customer as a liability. There could also be a possibility that the customer may cancel the order; in such a case, the firm will have to repay the customer as per the signed agreement.
Agreements made between customers and firms can specify different terms and conditions. In this case, we will keep the payment received from the buyer in deferred revenue until we deliver the product or services to the customer, as mentioned in the contract. No revenue will be recorded unless we have rendered all the services. It is recorded as a current liability on the firm’s balance sheet, as prepayment terms are majorly for 12 months or less.
However, suppose the buyer made an up-front prepayment for services that need to be rendered over several years. In that case, the firm must record the payment segment regarding the services or products that need to be generated post 12 months from the payment date as deferred revenue under the long-term liability on its balance sheet.
Examples of Deferred Revenue
For example, ABC Inc receives a $3,600 payment in advance at the beginning of its fiscal year from a customer for an annual magazine subscription. Upon receiving the payment, the company records a debit entry in the cash and cash equivalent account and registers a credit entry in the deferred revenue account for $3,600.
Each month, ABC Inc supplies the magazine to its buyer and recognizes generated revenue. At the end of each month, we record a debit entry of $300 to the deferred revenue account and register a credit entry of $300 to the sales revenue account. By the end of the fiscal year, we have recorded the entire deferred revenue balance of $3,600 as revenue on the firm’s income statement at a rate of $300 per month, resulting in a balance of $0 in the deferred revenue account.
Types of Deferred Revenue
- Monthly advance rent received for property owned.
- Pre-payment is received for the subscription to a newspaper or magazine.
- Prepaid insurance.
- Prepaid software products.
- Prepayment received for hotel/room booking.
- Advance payment for providing loading/unloading or transport facilities.
Why is Deferred Revenue Considered Liability?
It is an advance payment that a firm receives for the services or products it will deliver. The firm has an obligation to the customer to deliver the required goods or services, so it records the receipt of payment in advance under the liabilities account on the balance sheet.
The firm may not be able to deliver the required goods or services in a prescribed time; hence, it recognizes the advance payment received from a customer as a liability. There could also be a possibility that the customer may cancel the order; in such a case, the firm will have to repay the customer as per the signed agreement.
Deferred Revenue Journal Entry
ABC Inc. received a $3,600 payment in advance on 01’April, 2019 from a customer for an annual magazine subscription. Upon receiving payment, the company records a debit entry in the cash and cash equivalent account and registers a credit entry in the deferred revenue account for $3,600.
Each month, ABC Inc supplies the magazine to its buyer and recognizes generated revenue. At the end of each month, we record a debit entry of $300 to the deferred revenue account and register a credit entry of $300 to the sales revenue account.
| Date | Account | Notes | Debit | Credit |
| 1/4/2019 | Cash | Payment for Magazine subscription | 3600 | |
| Deferred revenue | 3600 |
| Date | Account | Notes | Debit | Credit |
| 1/5/2019 | Deferred revenue | One month of Magazine subscription | 300 | |
| Revenue | 300 |
Importance of Deferred Revenue
- It helps in accurately reporting assets and liabilities on a firm balance sheet. The company avoids recording the Income on assets which has not yet been earned by registering deferred revenue in liability. Hence, Deferred revenue can avoid overvaluing the firm’s net worth.
- The Income obtained in advance is helpful in financing operations, thus mitigating the pressure on other assets or firms that do not need to take a loan.
- It represents the firm’s overall financial health by revealing the amount that the company owes to the customers. The firm faces a risk with the revenue obtained from the customer but not yet earned unless the product or service is rendered.
Difference Between Deferred Revenue and Accrued Expense
The firm receives payments in advance for products or services that have not yet been delivered or rendered. The firm incurs expenses that have already been incurred but are yet to be paid.
Examples: When a customer has already paid for a service, and the service is yet to be delivered, the payment received in advance will be considered Deferred Revenue.
While a customer has purchased a product and has to pay $3000, he has already mentioned that he will spend next month. Accrued expenses will consider the expenses incurred here.
Advantages of Deferred Revenue
- The firm will have revenue in advance, and the business needs to deliver the required goods or services and need not worry about payment default.
- The amount a firm has received in advance can be utilized in financing operations.
- Liabilities account for deferred income, which represents the income obtained by a firm but not yet earned. The firm will earn this income once it delivers the required services. Therefore, unearned income is not recorded in assets.
- Knowing the amount of Deferred Revenue allows an investor to analyze the firm’s financial health while investing. One, the investor will be able to know if the firm needs to provide services to the customer in the future; second high deferred revenue indicates that the firm already has no. of projects in the pipeline, which shows that the firm is running a good amount of business.
Conclusion
The firm recognizes the advance payment received from a customer under the liability section of the balance sheet because there is a possibility that it may not be able to provide the required goods or services in a prescribed time. The advance payment represents payments received in advance for products or services that have not been delivered or rendered yet.
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