Although receiving payments in advance before offering goods or services appears to bring cash to a business, the accounting standards have a unique approach to such situations. Deferred or unearned revenue is an income that a company receives from its customers before providing products or services to them. The obligation will not be completed until it is settled; therefore, the revenue will not be considered as earned.
Through this blog, we will help you to understand the meaning of deferred revenue and reasons for recording it on a balance sheet as a liability. We will discuss the following topics related to deferred revenue management and accounting:
What Is Deferred Revenue and Why Is It a Liability?
This takes place when a company makes money before it delivers its products or services to its customers. Since the company still owes something to the customer, it is accounted for under liabilities first before revenue.
How Deferred Revenue Works in Accounting
The accounting entry starts with receipt of the prepayment by the customer. The business will record the money received and recognize the related deferred revenue liability account. As the business provides the customer with the products/services as agreed, the relevant part of the deferred revenue is recognized as revenue.
This way, revenues are accounted for during the period when the business earns them. It allows presenting a more accurate representation of the firm's performance on the financial statements instead of recognizing all advance payments as income.
Why Deferred Revenue Is Classified as a Liability
Liabilities are obligations which have to be fulfilled by the organization in the future. In the case of deferred revenue, there is liability, because the firm has already received some payment from the customer but still has some performance obligations to complete.
Usually, this liability stays on the balance sheet until the fulfillment of this particular obligation takes place. However, in case the firm does not perform its obligations and needs to refund the money back, this is also the liability.
Deferred Revenue vs. Accounts Receivable
Deferred revenue and accounts receivable pertain to cash that is related to customer dealings, yet they have completely different settings. The deferred revenue scenario takes place when there is a customer who pays in advance, while accounts receivable deals with payments made after delivery.
|
Accounting Item |
Deferred Revenue |
Accounts Receivable |
|
Payment status |
Customer has already paid |
Customer has not yet paid |
|
Delivery status |
Product/service is still owed |
Product/service has been delivered |
|
Balance-sheet classification |
Liability |
Asset |
|
Main concern |
Fulfilling the obligation |
Collecting the receivable |
Understanding this distinction is important because recording deferred revenue incorrectly as earned income can overstate revenue and profitability.
How Businesses Can Manage Deferred Revenue Effectively
Deferred revenue management is not just about accounting for advance payment but about developing a system that manages customer agreements, cash flows, performance obligations, and revenues to allow for the timely reduction of liabilities.
Maintain Accurate Payment and Contract Records
The company needs to have complete documentation on each advance payment made by a customer detailing the name of the customer, agreement terms, amount of payment, duration of services, and revenue recognition policy. The information forms the basis of proper deferred revenue accounting.
The financial team should reconcile the deferred revenue documentation to the transactions carried out in the company’s bank account, invoices issued to customers, and the agreements between the company and its customers.
Create a Revenue Recognition Schedule
A revenue recognition schedule assists companies in determining the timing in which deferred amounts would be moved out from the liability side and recognized as earned income. For instance, in the case of a service contract for one year, the company could recognize the proper amount for each month of service.
These schedules need to reflect the contractual obligations as well as the necessary accounting requirements. By reviewing such schedules periodically, it would be possible to spot any contract changes, expiration, cancellation, etc.
Reconcile Deferred Revenue Accounts Regularly
Reconciliation is critical in helping organizations find out whether there is a match between the balance recorded in the deferred revenue account and the actual customer liabilities. The discrepancy may arise from an omission, an inaccurate journal entry, or failure to recognize revenue.
Periodic reconciliation is very helpful for companies with many customers. Reconciliation allows organizations to know early enough when there is any problem instead of learning about it during year-end financial reporting.
Best Practices for Deferred Revenue Management
An effective deferred revenue management strategy must entail proper documentation, adequate processes, suitable technology, and timely review. This can assist companies in ensuring accuracy in their financial reporting while minimizing risks of improper revenue recognition.
Use Accounting Software to Automate Tracking
The accounting system of today can assist companies in recording advance payments, issuing invoices on a regular basis, managing revenue flows, and creating financial statements. There is an opportunity to automate some processes in order to decrease the amount of manual entries.
When selecting an accounting program, the company has to find the solution that will support the number of transactions and the revenue model of the business.
Monitor Deferred Revenue on the Balance Sheet
Financial managers ought to frequently review the balance of deferred revenue and not simply allow this balance to grow without reviewing. Analyzing the balance relative to the company’s open contracts will show whether the balance is legitimate.
Also, a persistent high or fast-growing balance of deferred revenues might indicate useful business data for management that can be used in their planning.
Train Finance and Accounting Teams
The people who are involved in activities such as billing, accounting, finance reporting and revenue recognition should be trained on how to deal with deferred revenue. Any minor mistake could cause revenue to be recorded in an incorrect period of accounting.
The training program should include issues like the type of revenue model used by the company, the accounting policies and procedures related to changes in the contract.
Establish Internal Controls
Controls can assist in avoiding unauthorised changes, duplicate entries, and inappropriate revenue recognition. It is essential for firms to outline the people responsible for contract creation, payment recording, adjustments approvals, and revenue recognition scheduling.
The documentation of such a review process will also make it easy to detect any mistakes made prior to the finalisation of financial statements. This becomes more critical as the firm grows and the customer base expands.
Common Examples of Deferred Revenue
Deferred revenue can arise in many industries, especially when customers pay upfront for services delivered over a period of time.
Software and Subscription Businesses
Software-as-a-Service organizations usually get paid before delivering the entire software services in a month or in a year. The income generated is deferred initially and is recognized only when the organization delivers the software service to the customer.
For instance, when a customer pays an organization $1,200 for a service that will be provided over 12 months, then $100 can be recognized as revenue per month.
Professional Services and Retainers
Firms such as consulting firms, marketing agencies, legal practitioners, and many other service providers might receive retainers or advance payments for the agreed services prior to delivery. Depending on the terms of the contract, amounts received in advance for services yet to be delivered might have to be deferred until such services are delivered.
The practice of maintaining adequate records of engagements and income schedules might assist in determining the point in time at which amounts become earned.
Memberships and Annual Contracts
Gyms, trade associations, educational institutions, and other membership-based companies may receive advance annual payments. It could initially indicate an obligation to provide membership services during the entire duration of the contract.
With the provision of those services by the business, the right amount can then be recorded as income. This is made possible through a well-thought-out plan.
When Should a Business Consider Outsourcing Deferred Revenue Management?
Internal deferred revenue management becomes complex if a firm has many contracts, multiple cash flows, several sources of income, or inadequate accounting staff. It becomes more complicated as the number of transactions increases.
Benefits of Professional Accounting Support
Professional accountants may help firms set up procedures regarding deferred revenue accounting. In addition, professional accountants may go through their books to reconcile errors.
It may be important to hire external accountants to assist firms that have not assigned revenue-accountants. This would especially benefit small firms that are growing and have not been able to assign revenue-accountants.
Supporting Compliance and Accurate Reporting
Revenue Recognition can have an important impact on the profit and position of the organization in financial statements. In case of improper handling, it might lead to the preparation of financial statements that fail to reflect the performance of the business.
Professional assistance in the field of accountancy can add another level of scrutiny to the process and assist the business in maintaining proper documentation and accounting.
The topic of deferred revenue is very crucial in accounting since the receipt of money does not always mean that the revenue has been earned. The amount of money received by a company usually becomes deferred until the company meets its obligation to the client.
Efficient management of deferred revenue involves keeping good records, proper revenue recognition, frequent reconciliations, accurate accounting software, and good internal control measures. Companies with complicated or many contracts may also hire professional accounting services for efficient management of deferred revenue.
The Fino Partners provides professional accounting and bookkeeping support to help businesses organize financial records, manage deferred revenue, and maintain reliable reporting. Contact The Fino Partners to discuss a deferred revenue management solution tailored to your business.
