While invoicing systems have been around since the dawn of written language, in modern times, more businesses than ever receive payments from customers before delivering a good or service. If your small business operates on an asynchronous fulfillment model, you need to acquaint yourself with deferred revenue and how to report it.
In simplest terms, deferred revenue is revenue earned before rendering goods or services. Accountants and bookkeepers refer to this revenue as “deferred” because, while present in the books, it has not technically been earned yet; the company still must fulfill its end of the transaction agreement.
For the sake of example, let’s take a sole proprietor jeweler specializing in custom necklaces. A customer orders a custom necklace and is charged the final amount upon placing the order. The revenue earned from this transaction is considered “deferred” — at least until the jeweler fulfills the order by creating and delivering the necklace, completing the purchase agreement.
For businesses that provide services rather than goods, there are instances in which deferred revenue becomes realized over time instead of all at once. For example, imagine a landscaping company. A client signs a yearlong service contract for a one-time upfront payment with the company. As the landscaper continually renders services over the contract period, equivalent parts of the payment become realized on the income statement.
Deferred revenue is listed as a liability on a company’s balance sheet. This represents a good or service that the business still owes to the customer — and if the business fails to hold its end of the bargain, the customer may cancel the transaction and request a refund.
In most cases, the prepayment terms for deferred revenue last for 12 months or less. As a result, bookkeepers will typically classify deferred revenue as a current liability on a balance sheet. However, if a client delivers an upfront payment for a multi-year deal, the resulting deferred revenue becomes a long-term liability.
GAAP, or Generally Accepted Accounting Principles, has a wide-reaching influence on all accounting matters — let alone deferred revenue — specifically, the third and tenth Principles of GAAP: the Principle of Sincerity and the Principle of Uberrimae Fidei (Utmost Good Faith), respectively. Deferred revenue has an inherent uncertainty; in adherence to these principles, businesses must report revenues consistent with the lower boundary of uncertainty. To simplify this, let’s take an example: a writing house signs a year-long contract with a publisher. Under the terms of this contract, the writing house will receive an upfront payment plus royalties on print sales. Based on previous data, the writing house expects to receive between $15,000 and $20,000 per month in royalties; on the balance sheet, the writing house should value the deferred royalties at $15,000: the lower boundary of uncertainty. GAAP encourages this practice to promote accounting conservatism and prevent businesses from defrauding investors.
As previously mentioned, revenue that is deferred is not considered actual revenue until it is realized upon the delivery of a product or service. Because of this, it is not reported on an income statement; instead, deferred revenue is listed under the liabilities column on a balance sheet.
To visualize this, let’s take a look at a $5,000 upfront payment that qualifies as deferred revenue. Notice how as the asset column (cash) increases, so too does the liability column (deferred revenue).
Since deferred revenue is commonplace in the world of business, it’s only logical that deferred expenses also exist. An example of a deferred expense would be pre-paid rent on office space or a storefront. Deferred expenses follow similar principles as deferred revenue, just reversed; these expenses are listed under the assets column of a balance sheet until realized.
For example, let’s take a look at a business that pays its $60,000 annual rent bill upfront. The relevant balance sheet entries may look like this:
Notice how, with deferred expenses, cash is considered a liability, whereas the deferred expense is considered an asset.
It is essential to consider that rent is a special case; while the company paid a year’s rent upfront, it will be realized on a monthly basis — in this case, $5,000 at a time. Once a portion of the rent is realized, the business would record an entry like this:
|Realized Rent Expense||$5,000|
Once one month’s rent — $5,000 — becomes realized, it is subtracted from the prepaid rent figure and added to the realized rent expense.
Let’s take a look at a small IT consultancy firm that contracts its services to clients on a subscription basis. These 12-month subscriptions cost $500 per month, billed as a one-time $6,000 fee.
Let’s say Company A purchases a subscription from this IT firm on July 1st. The IT firm’s specialized small business accountants would make an entry into the balance sheet that looks like this:
|Deferred Revenue (Subscription Fee from Company A)||$6,000|
Because the subscription costs $500 per month, the first $500 of revenue will be realized on August 1st. The IT firm’s accountants will record the realized revenue on the income statement before making a balance sheet entry that looks like this:
|Realized Revenue (Subscription Fee from Company A)||$500|
|Deferred Revenue (Subscription Fee from Company A)||$500|
When running a small business, a highly competent financial team can provide essential business insights, find crucial tax savings, and allow business owners to spend less time stressing the financials and more time serving customers. If you want to elevate your business’s financial team, look no further than FinancePal’s team of experienced small business bookkeepers and accountants. Sign up to get a custom quote today for FinancePal’s professional financial services.
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