What is Deferred Revenue for Small Businesses?
Deferred revenue, unearned revenue or deferred income, is a crucial accounting concept that businesses must understand. It refers to the payments a business receives in advance for goods or services that have not yet been delivered or fulfilled. This situation typically arises when customers pay upfront for a service or product that will be provided at a future date, such as annual subscriptions, prepaid services, or deposits for future goods.
When a company receives such payments, it records them as deferred revenue, a liability on its balance sheet. This is because the company has an obligation to deliver the goods or services in the future. Until it fulfills this obligation, the revenue cannot be recognised as earned. This approach aligns with key accounting principles, ensuring that revenue is recognised only when the product or service is provided.
Understanding deferred revenue is vital for small businesses as it helps them maintain accurate financial records, manage cash flow effectively, and ensure transparency in their financial statements. It also aids in assessing the company’s financial health by accurately tracking deferred revenue and analysing its impact on the balance sheet and income statement.
In this article, we will look at what is deferred revenue, how to calculate it and how to record it in the accounts. We have included a free calculator and template to help with the calculations.
Examples of Deferred Revenue
Below are several examples of deferred revenue:
Subscription-based services – If a customer pays in advance, the amounts are deferred until recognised during the membership period.
Deposit for goods or Services – If you receive a deposit for goods or services, this is treated as deferred revenue and will appear in the income statement when the goods or services are delivered.
Service Contract – If a customer pays for a service contract covering a period, it will be recorded as deferred revenue.
Insurance – If insurance is received in advance, it is accounted for during the year.
How to Prepare a Deferred Revenue Journal Entry
Preparing a deferred revenue journal entry involves recognising the cash received for goods or services that have yet to be delivered as a liability. This ensures compliance with accrual accounting principles, where revenue is only recorded when earned. Here’s how to prepare it:
- Initial Entry: When a company receives an upfront payment from a customer, it records this transaction by debiting the cash account and crediting the deferred revenue account. This entry reflects the company’s obligation to deliver the goods or services in the future.
- Debit: Cash Account
- Credit: Deferred Revenue Account
- Revenue Recognition: As the company delivers the goods or services, it gradually recognises the revenue. This involves decreasing the deferred revenue account and increasing the revenue account.
- Debit: Deferred Revenue Account
- Credit: Revenue Account
This method ensures that the company’s financial statements accurately reflect its financial position, aligning with accounting standards like the generally accepted accounting principles (GAAP). Regularly updating and reviewing deferred revenue accounts is crucial for financial transparency and effective cash flow management.
How to Calculate Deferred Revenue
Calculating deferred revenue is about determining how much of the upfront payments you’ve received hasn’t yet been earned because you haven’t delivered the goods or services. Here’s a breakdown of how to approach it:
1. Identify Deferred Revenue Payments:
First, you need to know the total amount of cash you’ve received from customers that will be delivered in the future. This could be from subscriptions, prepaid services, or advance product orders.
Determine the Earning Period:
For each deferred revenue payment, identify the period you will deliver the goods or services. This might be a month, a quarter, a year, or the duration of a specific project.
Allocate Revenue Over the Earning Period:
Divide the total advance payment by the total earning period to determine how much revenue can be recognised in each period.
Calculate Deferred Revenue at a Specific Point in Time:
At any given point, your deferred revenue balance is the total amount of the initial advance payments for which you have not yet delivered the goods or services.
Deferred Revenue Example
Example 1: Annual Subscription
- A customer pays you £1200 upfront for a 12-month subscription.
- Earning period: 12 months
- Revenue recognised monthly: £1200 / 12 months = £100 per month.
- Deferred revenue after 1 month: £1200 – £100 = £1100
- Deferred revenue after 6 months: £1200 – (£100 x 6) = £600
- Deferred revenue after 12 months: £1200 – (£100 x 12) = £0 (all revenue is now earned)
The two journals below show the initial amount posted to the deferred account on the balance sheet and the monthly journal to move the earned revenue from the deferred account to sales on the income statement.
| Debit | Credit | |
|---|---|---|
| Cash Account | 1200 | |
| Deferred Revenue | 1200 |
| Debit | Credit | |
|---|---|---|
| Deferred Revenue | 100 | |
| Sales | 100 |
Deferred Revenue Recognition Calculator
Our deferred revenue recognition calculator is a valuable tool designed to help businesses accurately track revenue recognition. Using this calculator, you can easily determine how much of your advance payments should be recognised as revenue over a specified period. Here’s how it works:
- Enter the Amount of Transaction: Start by inputting the total amount of the upfront payment or transaction. This represents the cash your company has received that will be delivered in the future.
- Number of Earning Periods: Specify the total number of months over which the revenue will be earned.
- Number of Months Income Recognised: Indicate the number of months over which you want to recognise income. It will calculate the remaining deferred revenue balance.
Deferred Revenue Template
Our deferred revenue template is a tool designed to streamline the process of recording and managing deferred revenue. This template allows businesses to track the details of each transaction, ensuring precise revenue recognition over the designated period. Here’s how it works:
- Record Invoice Details: Start by entering the essential details of each invoice, including the customer name, invoice date, total amount, deferred amount, and the number of months over which the revenue will be recognised.
- Calculate Deferred Revenue per Month: The template automatically calculates the deferred revenue per month by dividing the deferred amount by the specified months.
- Post Deferred Amount Monthly: Enter the deferred amount in the correct months and check that the total amount equals the invoice’s total. If there is a difference, adjust the figures.
- Monthly Summary of Deferred Revenue: The template provides a comprehensive overview of the total deferred revenue for all monthly invoices.
- Journal Entry: The monthly amount is journaled on the balance sheet to reduce deferred revenue balance and as income on the profit and loss report.
Below is an example of the template.
Businesses can use our deferred revenue template to ensure accurate financial reporting, maintain transparency, and make informed decisions based on a clear view of their deferred revenue obligations.
Is a Deposit Always Deferred Revenue or Unearned Revenue?
A deposit might differ from deferred revenue if the deposit is due to be repaid. An example is a deposit for a rental that is held until the end of the rental period and then refunded. The deposit is, therefore, held in a different account, ensuring it is not used.
Deferred Revenue on the Cash Flow Statement
A cash flow statement shows when a cash payment is received or spent in the future. It usually shows a year. A business will, therefore, show the deferred revenue when the payment is received rather than when it is recognised as revenue on the income statement.
Accrued Revenue vs Deferred Revenue
One pair of terms that can get confusing is accrued and deferred revenue. Deferred revenue is money a company receives in advance for services or products it will deliver later.
Accrued revenue is income earned by providing services or products already delivered but not invoiced or paid. An example is if you are working on a large project that takes several months but gets paid at the end of the project. The revenue is reported when the work takes place each month.
Accounting Principles and Deferred Revenue
Understanding accounting principles is essential when dealing with deferred revenue. Deferred revenue, often called unearned revenue, occurs when a company receives payment before delivering goods or services. This is a common scenario in businesses offering subscriptions or prepaid services.
- Accrual Accounting: Under this principle, revenue is recognised when earned, not necessarily when cash is received. This means that even if a customer pays upfront, the revenue will only be recognised once the service is delivered or the product is provided.
- Revenue Recognition Principle: This principle ensures that a company only shows actual revenue when it has fulfilled its obligation to deliver goods or services. It helps maintain accuracy in financial reporting by matching revenue with the period it earned.
- Matching Principle: This principle matches revenues with the expenses incurred to generate them within the same accounting period. Deferred revenue means recognising the revenue when the service or product is provided.
- Consistency Principle: Companies should consistently apply accounting methods from one period to the next. This ensures that deferred revenue is treated the same across reporting periods, providing clarity and comparability in financial statements.
By adhering to these accounting principles, businesses can ensure financial transparency and accuracy in their financial statements, reflecting the proper financial health of the company. Managing deferred revenue is crucial for making informed business decisions and maintaining stakeholder trust.
Using Accounting Software
QuickBooks Advanced Online offers a deferred revenue feature that simplifies the management of deferred revenue for businesses. This feature is designed to help companies accurately track deferred revenue, ensuring compliance with key accounting principles and enhancing financial transparency.
The deferred revenue feature in QuickBooks Advanced allows businesses to record upfront payments as liabilities, reflecting the company’s obligation to deliver goods or services in the future. As the company fulfils these obligations, QuickBooks automatically adjusts the deferred revenue account, moving the appropriate amounts to the revenue account. This automation ensures that revenue is recognised in the correct accounting period, aligning with generally accepted accounting principles (GAAP).
Conclusion
Deferred revenue is essential in accounting as it ensures financial statements accurately reflect a company’s earnings and obligations. By recognising revenue only when goods or services are delivered, businesses maintain transparency and make informed decisions. Deferred income is a liability on the balance sheet and is posted to the income statement when the revenue recognition occurs.
This practice not only aids in accurate reporting but also supports a company’s financial health by giving stakeholders a clear view of its financial position. Managing deferred revenue helps businesses predict future revenues, enhancing their ability to plan and grow. Understanding deferred revenue principles is crucial for maintaining financial integrity and building trust.
