When Should Deferred Revenue Be Recorded in Your Financial Statements?
A business can recognize some revenue in the period it was delivered while deferring the rest to a later accounting period. This can be done because of uncertainties around when the company will receive payments or uncertainty around its ability to deliver on its promises.
The accounting treatment of deferred revenue ultimately depends on the standards your company is following. Some organizations will also work with their auditors to get a tailored approach.
So, when does your organization recognize deferred revenue in its financial statements? Read on to find out!
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What Is Deferred Revenue?
Deferred revenue is money that has been received for a product or service that has yet to be provided. It’s also known as unearned revenue.
This is recognized as a liability on the business’s balance sheet since the customer has already paid for what has not yet been delivered. As the products or services are offered, the deferred revenue will become revenue for the company.
Deferred revenue can also be used to track customer lifetime values and forecast future revenue. In short, deferred revenue is an essential tool for understanding cash flow and forecasting future income.
Common Deferred Revenue Scenarios in Business
In a subscription business model, clients prepay for services over a period of time; the revenue is only recognized as the company delivers the services or products.
Common deferred revenue scenarios in business occur when a customer has made a payment for a service or product. But the service or product is not ready for delivery. In this case, the revenue earned from the customer is deferred and the money is collected upfront by the business. This money is held over time until the product or service can be provided to the customer.
An example of this is a 3-year software subscription. Customers make a payment at the start of the subscription, but can only access the software once it is ready.
Until then, the money is deferred and held in the business’s books as deferred revenue. Other scenarios include advance payments for contracts and prepayments/deposits for services.
Benefits of Utilizing Deferred Revenue
It is common among businesses that provide services or sell goods repeatedly over a certain period.
Utilizing and knowing how to prepare deferred revenue is highly beneficial. It allows a business to start receiving payments before the actual services have been provided. This provides cash flow stability. It allows the business to cover its expenses while waiting to receive full payment.
Utilizing deferred revenue allows businesses to maximize their receivable collections and minimize their liabilities. This allows them to appropriately manage their books to obtain a better cash flow. It also provides access to additional financing options due to improved finances.
Deferred revenue helps businesses improve cash flow and reduce their risks, which gives them the ability to focus more on the day-to-day operations of their business.
Tracking and Accounting for Deferred Revenue
Tracking and accounting for deferred revenue is a crucial part of properly accounting for a business. The amount of deferred revenue is recorded as a liability on the balance sheet.
Deferred revenue eliminates the paid products or services that have been delivered. It’s then recognized as revenue instead of deferred revenue. As long as there are no refunds, the amount of deferred revenue should remain the same until it is time to recognize it.
To ensure accuracy, businesses should track and update deferred revenue figures on a regular basis.
Best Practices for Allocating Deferred Revenue
Best practices for allocating deferred revenue should involve accurate record-keeping and periodic updating of the balance sheet.
Revenues should be recognized when services have been provided. Contracts should only be recorded when the associated obligations have been met. To avoid recognition errors, all transactions should be categorized, recorded, and tracked properly.
It is also important to report any changes or modifications to deferred revenue contracts in a timely manner. For long-term projects and contracts, allocating deferred revenue should be done on a periodic basis.
Clear communication between the parties involved is vital. This ensures that all obligations and payments are tracked so that proper revenue recognition takes place.
Examples of Deferred Revenue
Deferred revenue is money that you have earned but hasn’t received yet. Here are some common samples of deferred revenue:
Online preorders are a common example of deferred revenue. Many companies offer exclusive preorder deals. Preorders for books, music, video games, software, and mobile apps, are some of the most common.
Companies may also offer preorders for services. Examples of services are subscriptions, upgrades, or one-time payments. The customer may prepay for the item or service, but will not receive it until the specified date.
Companies recognize deferred revenue when and defer recognition of the revenue until they fulfill the product or service.
Subscriptions involve a customer that pays upfront for services or products. These are then delivered at later date.
This can come in the form of subscription services. These services might be satellite TV, magazine, or newspaper subscriptions. Memberships to clubs and other recreational activities are also deferred revenue. This is because customers pay before they receive the service.
Customers are paying the vendor an upfront cost with the expectation of the service or product being delivered in the future.
When a customer purchases a gift card, they are pre-paying for goods or services they wish to use at a later date. The funds are held in a trust or bank account until they are ready to be used. This is why they are classified as deferred revenue.
There are different examples of deferred revenue gift cards. These can be prepaid debit cards, prepaid cellular phone cards, prepaid gasoline cards, and prepaid tickets.
By offering these cards, businesses can increase their liquidity and reduce their working capital requirements. Furthermore, depending on the jurisdiction, deferred revenue gift cards may reduce a business’s taxation burden. Given the advantages, deferred revenue gift cards are becoming an increasingly popular form of payment.
Booking a Flight
An example of deferred revenue booking a flight is when a customer pays in advance for an airline ticket. The company will record the payment. But then it will defer recognition of the revenue until the flight takes place.
The revenue is recognized only when the service has been provided. This is beneficial because both the customer and the airline are able to plan ahead. This results in a long-term relationship with the transaction.
Customers can look forward to future flights without worrying about pricing and availability. The airline can rely on the promise of payment in the future. They will also plan for the customer’s travel expectations.
In the end, both the customer and the company enjoy deferred revenue booking.
Is Deferred Revenue Considered a Liability?
Deferred revenue is a liability as it is money received in advance for goods or services that have yet to be provided.
As such, the company is obligated to provide the relevant goods or services at a later date. Generally, deferred revenue is recorded as a liability on the balance sheet and presented as unearned revenues until the company fulfills its obligation to its customers.
Pros of Deferred Revenue
Deferred revenue is a key source of revenue for businesses. It helps to smooth out cash flow, providing a consistent source of funds without needing to be reinvested into production or marketing.
Here are the advantages of deferred revenue:
Protects Against Bad Debt
Companies that accept payments in advance are able to secure a guaranteed line of income and are able to manage their finances better. If a customer fails to pay the full amount they owe, the company is already guaranteed to have part of the debt covered.
This reduces the risk of having to write off bad debt. It also removes any uncertainty surrounding payment collection. Companies may gain increased liquidity as customer payments come in earlier than normal. This can be especially beneficial during lean periods, when funds may be needed to cover overhead or make investments.
Getting paid in advance for services or products being delivered is an effective way to protect against bad debt.
Will Eventually Show Up as a Sale
A deferral of revenue means that a company has collected the payment upfront. This allows a company to plan for future sales and ensure that there is money to be made.
Businesses know precisely how much money they will be receiving on a certain date in the future. This is helpful in budgeting and forecasting, as it gives the business a benchmark of how much money will come in on specific dates.
The revenue shows up as sales in the future, making the company’s financial statement look more impressive. This feature of deferred revenue can be used to sound impressive and attract more potential investors and customers.
Improved Cash Flow
Deferred revenue provides businesses with upfront payment. This stabilizes cash flow, and businesses can use this money as a kind of working capital.
Businesses can also use deferred revenue to take advantage of short-term investments and interest. By having prepaid profits, businesses will have access to more working capital in order to invest in growth opportunities. This leads to an improved financial position.
Deferred revenue is, therefore, a great way for businesses to obtain the capital they need and achieve financial solidity.
Cons of Deferred Revenue
Deferred revenue can be a useful accounting tool in some cases, but it does have its drawbacks.
Here are some cons of deferred revenue:
Can Affect the Financial Status of a Company
Deferred revenue can adversely affect a company’s financial status in several ways. First, the deferral of revenue increases the company’s accounts receivable balance. This can affect a company’s liquidity, as the company will not be able to access those funds until a later date.
The deferral of revenue can result in a decrease in its current cash flow. This can limit the amount of cash available for operations. This impacts a company’s ability to meet its daily obligations.
Deferred revenue can hide the true level of a company’s performance. Potential investors may not be able to accurately assess the company’s ability to generate income in the near future.
It is important for companies to carefully consider the potential drawbacks of deferring revenue before implementing such a strategy, as it can have a significant impact on a company’s financial health.
Creates an Obligation to the Customer
The primary con of deferred revenue for businesses is the financial obligation it creates. If a business fails to deliver on this obligation, the customer is entitled to a refund. This creates a potential financial loss for the business.
Customers may become disgruntled if goods and services aren’t provided as anticipated. Potentially leading to reputational damage and driving them away. Businesses should assess their financial and operational readiness to accept deferred revenue.
A business must make sure it can fulfill the anticipated obligations to customers.
May Not Be Able to Keep Up With the Demand
If a company takes in too much revenue upfront and cannot deliver on the promised goods or services, it may not be able to adjust.
This could lead to serious financial consequences for the company. Refunds and reimbursements may not be fulfilled. Customers may lose confidence in a company that fails to meet their needs. Leading to potential long-term damage to the company’s reputation.
It is important for a company to consider how much-deferred revenue to take on. The cost of not being able to meet customer needs may be greater than the benefits of immediate cash inflow.
Know When to Recognize Deferred Revenues Starting Today
Deferred revenues, when recognized, can greatly affect the financial position of a business. Ultimately, it is important to have consistent, up-to-date revenue deferral policies that can be easily tracked and reported.
To learn more about this important topic and further improve your finance, accounting, and tax knowledge, consider taking an online course.
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