Deferred revenue, also known as unearned revenue, is a liability on a company’s balance sheet representing advance payments received for products or services yet to be delivered or performed. It’s a crucial accounting concept that ensures revenue is recognized at the appropriate time, aligning with the principle of accrual accounting.
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What is Deferred Revenue?
Deferred revenue, also known as unearned revenue, refers to payments a company receives in advance for goods or services it has yet to deliver. Since the company has not fulfilled its obligation, this money is considered a liability, not income. The concept of unearned Revenue is commonly found in industries like subscription-based services, software companies, insurance, and airlines.
Example:
Imagine a magazine company that sells an annual subscription for $120. The customer pays the full amount upfront, but the company will deliver the magazines throughout the year. The $120 is considered deferred revenue at the time of payment because the service (delivery of magazines) hasn’t been fully provided yet.
1. Concept of unearned revenue
Deferred (unearned) Revenue represents the money received in advance that the company owes as a product or service. It is classified as a liability because the company still has an obligation to deliver. Once the company fulfills its part of the deal (delivers the goods or services), the revenue is recognized as earned and moved from the liability section to the income section in the financial statements.
2. Accounting Entries for Deferred (unearned revenue) Revenue
Initial Journal Entry (When payment is received)
When a customer makes an advance payment for goods or services, the company will create the following journal entry:
- Debit (Dr): Cash or Bank (Increases assets)
- Credit (Cr): Deferred Revenue (Increases liabilities)
Journal Entry when Revenue is Earned
Once the goods or services have been delivered, the deferred revenue is recognized as earned revenue:
- Debit (Dr): Deferred Revenue (Decreases liabilities)
- Credit (Cr): Revenue (Increases income)
Example of Accounting Entries:
Imagine a software company receives $6,000 upfront for a 12-month subscription. The company will earn $500 per month over the next 12 months.
- At the time of receiving payment:
- Dr Cash $6,000
- Cr Deferred Revenue $6,000
- At the end of each month (as revenue is earned):
- Dr Deferred Revenue $500
- Cr Revenue $500
3. What Reports Deferred (unearned revenue) Revenue?
Deferred (unearned) Revenue is reported on the Balance Sheet under the liabilities section. Since it represents a company’s obligation to provide goods or services in the future, it is classified as a liability. The balance sheet will show:
- Current Liabilities: Deferred (unearned) Revenue related to obligations within the next 12 months.
- Long-term Liabilities: Deferred (unearned) Revenue for obligations that extend beyond 12 months.
4. The Three Statements of Deferred (unearned revenue) Revenue
Deferred (unearned revenue) Revenue impacts three key financial statements:
- Balance Sheet:
Deferred (unearned) Revenue is shown as a liability (current or long-term) until the goods or services are delivered. - Income Statement:
Once the revenue is earned, it is moved from the Deferred (unearned) Revenue liability account and recognized as income on the income statement. - Cash Flow Statement:
When Deferred (unearned) Revenue is initially received, it is reflected as a cash inflow from operating activities since the company has received cash upfront, even though the revenue has not yet been earned.
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5. How to Show Deferred Revenue on the Balance Sheet
On the balance sheet, Deferred (unearned revenue) Revenue is listed as a liability, usually under the current liabilities section if the obligation will be fulfilled within the next 12 months. If the delivery of goods or services is expected to take longer than 12 months, it may be categorized under long-term liabilities.
6. Journal Entry for Deferred (unearned revenue) Revenue
- Initial Entry (When payment is received):
- Dr: Cash (asset)
- Cr: Deferred Revenue (liability)
- Subsequent Entry (When revenue is earned):
- Dr: Deferred Revenue (liability)
- Cr: Revenue (income)
Example:
A company receives $10,000 for a service contract that will be fulfilled over 5 months.
- At the time of receiving payment:
- Dr Cash $10,000
- Cr Deferred Revenue $10,000
- At the end of each month (recognizing $2,000 revenue):
- Dr Deferred Revenue $2,000
- Cr Revenue $2,000
7. How to Calculate Deferred Revenue
Deferred (unearned revenue) Revenue is calculated based on the advance payments received for services or products yet to be delivered. The formula is:
Deferred (unearned revenue) Revenue = Payment Received – Revenue Earned
Example:
A company receives $12,000 for a 6-month subscription, delivering $2,000 worth of service each month. After 3 months:
- Deferred (unearned) Revenue = $12,000 – ($2,000 × 3 months)
- Deferred (unearned) Revenue = $12,000 – $6,000 = $6,000 remaining as Deferred (unearned) Revenue
8. What is Negative Deferred Revenue?
Negative Deferred (unearned revenue) Revenue occurs when a company has recognized more revenue than it has actually earned based on the advance payments received. This situation usually arises from an accounting error, where revenue is recognized prematurely before the related service or product is delivered.
Example:
If a company receives $10,000 for a service contract but mistakenly recognizes $11,000 as revenue, it will create a negative deferred revenue balance of -$1,000. This will need to be corrected in the subsequent period by adjusting the entries.
9. Is Deferred Revenue a Debit or Credit?
Deferred (unearned revenue) Revenue is always recorded as a credit because it represents a liability. It shows the company’s obligation to deliver goods or services in the future. When the obligation is fulfilled, deferred revenue is debited to reduce the liability, and revenue is credited to reflect earned income.
10. What is the Double Entry for Deferred Income?
Deferred income follows the double-entry accounting principle:
- When payment is received:
- Debit: Cash (increase in assets)
- Credit: Deferred Revenue (increase in liabilities)
- When the revenue is earned:
- Debit: Deferred Revenue (decrease in liabilities)
- Credit: Revenue (increase in income)
Example:
A company receives $15,000 for a 5-month service contract.
- At the time of payment:
- Dr Cash $15,000
- Cr Deferred Revenue $15,000
- Each month, for 5 months (recognizing $3,000/month):
- Dr Deferred Revenue $3,000
- Cr Revenue $3,000
Conclusion
Deferred (unearned revenue) Revenue represents an important concept in accounting, particularly for businesses that receive payments upfront for goods or services to be delivered in the future. By correctly classifying and managing deferred revenue, companies can maintain accurate financial records and ensure that their financial statements provide a clear picture of their obligations and financial health. Understanding how to handle deferred revenue through journal entries, financial reporting, and recognizing revenue at the appropriate time is essential for both accountants and business owners.
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