Deferred Revenue Journal Entry: What is Deferred Revenue in Small Business from David Adam's blog

Recognizing revenue prematurely can distort your perception of your company's financial well-being, underscoring the critical significance of comprehending revenue recognition for business proprietors. A pivotal facet of this subject matter lies in the notion of deferred revenue. But what exactly constitutes deferred revenue in accounting, and how does it pertain to your enterprise? Let's delve deeper into deferred revenue through our concise elucidation.

 

Deferred revenue is a fundamental accounting concept wherein a company records income received in advance but has not yet fulfilled its obligations or provided the corresponding goods or services. It's a liability on the balance sheet, representing the commitment to deliver on customer promises. This concept is particularly prevalent in subscription-based businesses, software companies, and industries where prepaid contracts are commonplace.

Understanding deferred revenue is vital because it helps accurately portray your company's financial position. It ensures that revenue is recognized only when the performance obligations are met, promoting transparency and preventing financial misrepresentations. By exploring deferred revenue in greater depth, you'll equip yourself with the knowledge needed to make informed financial decisions and maintain the integrity of your business's financial health.

Definition of Deferred Revenue

 

Deferred revenue, also known as "unearned" or deferred income, pertains to revenue collected from customers before their actual earnings. This could include scenarios such as prepayments for a substantial web design project, upfront yearly rent payments, or legal service retainers.

The balance sheet records deferred revenue journal entry as a short-term or current liability. Unlike long-term liabilities extending beyond a year, current liabilities are anticipated to be settled within a year. Think of deferred revenue as a short-term liability resembling a debt, but instead of money owed, it signifies goods and services owed to customers.

 

Deferrals, including deferred revenue, are standard accounting practices employed to ensure the precise recording of income and expenses during the relevant period. For instance, law firms often use deferred revenue, as seen in retainer fees. When a legal practice charges a new client a $10,000 retainer fee, it doesn't instantly register this sum as revenue. Instead, it initially records it as deferred revenue, acknowledging $10,000 in revenue only once the complete retainer fee has been earned. This approach ensures a more accurate representation of financial transactions aligned with when they are genuinely realized.

Is Deferred Revenue Considered a Liability? 

 

Yes, indeed. Deferred revenue should be classified as a liability, not an asset, on your company's balance sheet. This category is deserved because it designates income that has not yet been achieved and represents a responsibility to provide a development or service to the consumer. For example, if you conduct a subscription benefit and a customer withdraws, you must reimburse the payment for the new period. Therefore, even though deferred revenue appears in your business's bank account, it cannot be recognized as revenue at that point. Additionally, it's essential to note that in most cases, deferred revenue is reported as a current liability since prepayment terms typically extend for less than 12 months.

Provide an Example of Deferred Revenue in the Company

 

To better grasp deferred revenue in accounting, consider this example: Picture a landscaping firm, Company A, contracted to offer landscaping design services for a commercial property. Company A submits a quotation for $20,000, dividing the fee into two parts: $15,000 upon contract signing and $5,000 upon project completion. Anticipating a 50-day project duration, Company A agrees to initiate work five days after receiving the initial $15,000 down payment.

 

So, when Company A receives the $15,000 payment on July 1 and commences work on July 6, their accounting entry will reflect a debit of $15,000 to cash and a corresponding credit of $15,000 to deferred revenue. Consequently, the balance sheet will display a current liability of $15,000 at that point. By July 31, approximately 50% of the project will have been completed. Consequently, an adjusting entry must be made (dated July 31), debiting deferred revenue for $10,000 and crediting the income statement with the same amount ($10,000). Consequently, the July 31 balance sheet will indicate deferred revenues of $5,000, signifying the outstanding liability from the initial $15,000 down payment.