What is deferred income?
Deferred revenue, also known as unearned revenue, refers to the prepayments that a business receives for products or services that need to be delivered or performed in the future. The company receiving the prepayment records the amount as deferred revenue, a liability, in its balance sheet.
Deferred revenue is a liability because it reflects unearned revenue and represents the product or service owed to a customer. Since the product or service is delivered over time, it is recognized proportionally as income in the income statement.
Key points to remember
- Deferred revenue is a liability on the balance sheet of a business that represents an advance payment by its customers for goods or services that have not yet been delivered.
- Deferred revenue is recognized as revenue earned in the income statement when the good or service is delivered to the customer.
- Use of the deferred revenue account follows GAAP guidelines for accounting conservatism.
- If the good or service is not delivered as planned, the company may be liable to its customer.
Operation of deferred income
Deferred revenue is recognized as a liability on the balance sheet of a business that receives an advance. Indeed, he has an obligation to the customer in the form of the products or services due. Payment is considered a responsibility towards the company because it is always possible that the good or service is not delivered, or the buyer could cancel the order. In both cases, the company must reimburse the customer, unless other payment conditions are explicitly stipulated in a signed contract.
The contracts may stipulate different conditions, according to which it is possible that no product will be registered until all the services or products have been delivered. In other words, the payments received from the customer would remain in deferred revenue until the customer has received in full what was due in accordance with the contract.
Generally accepted accounting principles (GAAP) require certain accounting methods and conventions that encourage accounting conservatism. Accounting conservatism ensures that the company reports the lowest possible profit. A company that reports income conservatively will not recognize the income earned until it has completed certain tasks to have a full claim for money and once the probability of payment is certain.
As a general rule, when a business provides services or products, the deferred income is gradually recognized in the income statement to the extent that the income is “earned”. Classifying deferred income as income earned too quickly, or simply bypassing the deferred income account all together and posting it directly to income in the income statement is considered aggressive accounting and effectively overestimates income of sale.
Deferred revenue is generally presented as a short-term liability on the balance sheet of a business, since the terms of early repayment are generally 12 months or less. However, if a customer has made an initial prepayment for services which should be provided over several years, the part of the payment which relates to the services or products to be supplied after 12 months from the date of payment must be classified as income. deferred. under the long-term liabilities section of the balance sheet.
Example of deferred income
Deferred revenue is common with subscription products or services that require prepayment. Examples of unearned income are rent payments received in advance, prepayment received for newspaper subscriptions, annual prepayment received for use of the software, and prepaid insurance.
The other company involved in a prepayment situation would record its anticipated cash expenses as prepaid expenses, an asset account, on its balance sheet. The other business recognizes its prepaid amount as an expense over time at the same rate as the first business recognizes the income earned.
Take the example of a media company that receives an advance payment of $ 1,200 at the start of its fiscal year from a client for an annual newspaper subscription. Upon receipt of payment, the company’s accountant records a debit entry in the cash and cash equivalent account and a credit entry in the deferred income account of $ 1,200.
As the exercise progresses, the company sends the newspaper to its client every month and recognizes the revenues. Each month, the accountant records a debit entry in the deferred income account and a credit entry in the sales income account for $ 100. At the end of the year, the entire balance of deferred revenue of $ 1,200 was gradually recognized as revenue in the income statement at the rate of $ 100 per month. The balance is now $ 0 in the deferred revenue account until next year’s advance payment.