If you’re using the accrual method of accounting, you’ll need to make sure that any revenue your business receives is recorded in accordance with the revenue recognition principle. This principle states that revenue should be recognized in the same period in which goods or services are provided.
In simpler terms, any money your business receives from a customer in advance of goods and services delivered will need to be recorded as deferred revenue, including deposits, prepayments, and retainers.
Also known as deferred income or unearned revenue, deferred revenue needs to be recorded differently than accrued revenue or accounts receivable.
Overview: What is deferred revenue?
As a small business owner, being paid in advance for goods and services can provide a needed boost to cash flow. But as welcome as those funds may be, they’ll need to be handled a little differently than standard revenue.
Some examples of deferred revenue include:
- Retainers received by attorneys, accountants, or other professionals
- Prepaid insurance
- Cleaning and landscaping services
- Subscriptions and memberships
- Monthly maintenance services for appliances and equipment
In addition to the services mentioned above, any deposit collected from a customer in advance should be considered deferred revenue and recorded as such.
Although it’s more common for service businesses, other types of businesses also need to account for deferred revenue. Manufacturing businesses often accept deposits for large orders in advance of delivery. Until the products are delivered, the deposit should be recorded as deferred revenue.
Why is deferred revenue important for small businesses?
As a small business owner, one of the most important things you’re tasked with is properly tracking business revenue and expenses. While this is best done using accounting software, even if you’re using manual accounting ledgers or spreadsheet software, you’ll still need to record transactions properly.
Deferred revenue is important for any business, even small businesses with limited financial activity. Let’s say your cleaning business receives a $10,000 prepayment from one of its customers to pay for the entire year up front.
Recording the entire $10,000 in the month it’s received will result in an overstatement of net income for that month, with a subsequent understatement of income for the following months.
This error in reporting results in inaccurate financial statements that can negatively affect your ability to attract investors or secure a loan or line of credit.
One reason why small businesses like deferred revenue is because it provides an influx of cash which can help offset business expenses. While this may be advantageous for businesses with limited cash flow, it’s important to remember that deferred revenue is a liability until a product or service has been delivered.
If a product or service cannot be delivered, you may have to offer your customers a refund, which can be difficult if cash has already been used to cover other expenses.
Deferred revenue vs. unearned revenue: What’s the difference?
There is no difference between deferred revenue and unearned revenue, as both indicate the same thing — revenue that has been received for goods and services that have not yet been provided.
How does deferred revenue work?
When you invoice a customer for goods and services and your customer pays immediately, that is considered cash revenue which is recognized immediately.
However, when your customer pays you for a year’s worth of services in advance, you’ll only recognize the first month of revenue as earned and record the balance as unearned revenue.
For example, you own a 10-unit apartment complex. While most of your tenants pay their rent monthly, there is one tenant who pays the entire year’s rent in advance. You receive a check in the amount of $12,000 on August 15, which you deposit immediately even though their lease does not begin until September.
Their prepayment of $12,000 would be recorded as deferred revenue in August. On September 1, you’ll need to record the first month’s rent as revenue, with the balance remaining in deferred revenue until the following month.
At that time, another $1,000 will be recorded as revenue, with the process continuing until the entire prepayment has been accounted for.
The entire amount would be recorded as deferred revenue, with an additional journal entry needed to record September rent.
The second journal entry reflects the reduction in deferred revenue and the recording of September rent revenue.
As another example, let’s say you currently work as an attorney, providing basic legal services to clients for $1,250 per month. One of your clients decides to prepay for the next six months and sends you a check in the amount of $7,500.
When you receive the payment, it will need to be recorded in the deferred revenue account since you have yet to provide the services for which your client has paid.
Since the legal services start in January, you’ll have to recognize January revenue with a journal entry:
This entry reduces the deferred revenue by the monthly fee of $1,250 while recognizing the revenue for January in the appropriate revenue account. This journal entry will need to be repeated for the next five months until the entire amount of deferred revenue has been properly recognized.
For prepayments on product sales, the journal entries are similar. For example, one of your customers orders 100 chairs from you at a cost of $50 per chair, for a total cost of $5,000.
Because you have to supply materials upfront, you request a deposit of $2,500. When your customer pays the deposit, it will need to be recorded as deferred revenue since you have yet to supply the chairs.
In May, you ship the first 50 chairs. At that time, you would recognize and record the sales revenue with the following journal entry:
Once the customer receives the chairs, they will pay you the $2,500 balance, which again will be recorded in deferred revenue until the next 50 chairs are completed and shipped. At that time, the balance in deferred revenue will be recognized and recorded as sales revenue.
Why is deferred revenue treated as a liability?
Deferred revenue is always considered a liability since it is a reflection of the goods and services that you currently owe your customers. Until those goods and services have been provided, any advance payments should remain in the deferred revenue account.
Know when to recognize revenue
If you’re using the cash accounting method, there’s no need to worry about revenue recognition since revenue is only recognized when cash is received.
However, if you’re using the accrual method of accounting, any prepayments, retainers, or deposits received from your customers in advance of goods and services supplied will have to be recorded as deferred revenue.
Recognizing revenue when it’s earned will also help you avoid issues such as misstated revenue totals, which can directly impact business growth as well as possible future funding from investors and lenders.
Original source: the blueprint