A business can earn revenue from its services immediately recorded onto the books. Revenue is any income earned by the sale of products or services. Traditionally, the income is received only after the product has been sold or the services have been delivered. Sometimes the client may pay up in advance before the products or services are delivered. In such cases, you may need to learn about deferred revenue.
A Brief Explanation Of Deferred Revenue
Every time the customer pays in advance, the income cannot be recorded as revenue. Instead, it will be considered deferred revenue and placed under the balance sheet’s liability side. Even though the move seems unfair from a business perspective, some rational reasons exist.
As the payment for the services or products is not ethically earned by the company, it cannot be held as revenue and recorded under the assets section. However, deferred revenue can be altered as soon as the services or products are delivered in good condition. The deferred revenue can be earned in instalments or completely, depending on the nature of the service.
The outline for deferred revenue is explained in the pointers below.
- When the company receives an advance payment, it is not deemed as earned. This is why it must not be confused with general revenue.
- The amount becomes a liability because it is an advance payment acquired by the company without providing the goods or services.
- The deferred revenue can only be earned by paying off the debt of goods or services.
Calculating And Recording Deferred Revenue
As mentioned, the deferred revenue is recorded on the balance sheet as a liability, whereas revenue is typically recorded as assets. This is because of income, and the products or services are not delivered. This is a type of precaution the company must take in case a return is requested or a similar circumstance.
The practice of not engaging the deferred revenue among the assets ensures the company has the fund untouched if they have to return it to the client. Hence, by putting the deferred revenue as a liability, the company won’t mix it up with its personal holdings and will create a whole new accounting error.
The deferred revenue account gets debited as soon as you receive a prepayment or an advance for goods and services yet to be delivered. On delivering the goods and services, the deferred revenue account gets credited.
The Principles Of Deferred Revenue Journal Entry
Deferred revenue journal entry refers to recording this onto the accounting books. This process is based on the rules of a Real Account. Under this rule, any payment received is considered a debit, or “debit what comes in”. However, credit is measured by the increase in total liability.
To Deferred Income A/c
It is natural for the company to look for ways to convert the deferred revenue into income and record it as an asset. And the easiest way is to give the clients what they want and earn the deferred revenue. The deferred account and the balance sheet are adjusted as soon as the goods or services are successfully delivered. This time, the Normal Account rule is kept in mind.
Deferred Income A/c…..Dr.
To Sales A/c
When Is The Right Time To Convert Deferred Revenue?
Although the traditional process clearly states how deferred revenue can be recorded and converted, it does not say when. This is because there is no particular time for converting set up as a ground rule. The payment stays in the deferred account until the conversion is complete. Technically, the income has to be earned, and the company achieves this by delivering the goods and services.
However, this overall delivery process and conversion may sometimes be difficult. And to simplify, time specifications are added, so the advance amount is gradually recognised as earned revenue. There are two ways to approach this issue; let us discuss that in a while.
Percentage Of Completion
This method insinuates the company to debit an amount from the unearned revenue account. This amount gets credited to the income account. However, there’s a catch: the percentage of service being delivered. Based on this percentage, the deferred revenue gets converted into parts.
Completed Contract Completion
The completed contract completion method creates a contract between the customer and the company. This contract is an agreement that specifically states the matter of prepayment, and both parties sign it. In this case, the payment may be collected in advance, but it only gets credited after the complete goods and services are delivered.
Most companies are required to know about deferred revenue as advances or prepayments are a very common matter. The introduction of eCommerce has further reinstated the sentiment. Without the knowledge of deferred revenue, accounting can be quite complex.