Why is Deferred Revenue Treated as a Liability?

Deferred revenue is payment received from a customer before a product or service has been delivered; however, the payment is not yet recognized as revenue. Deferred revenue, also known as unearned revenue, is listed as a responsibility on the balance sheet because, on an accrual basis, the revenue recognition the process is not complete.

Key points to remember

  • Deferred revenue is revenue received for services or goods to be delivered in the future.
  • Deferred revenue is recorded as a liability on a company’s balance sheet.
  • The cash received for the future product or service is recorded as a cash debit on the balance sheet.
  • Once revenue is earned, the liability account is reduced and the income account of the income statement is increased by the same amount.
  • The accrual method recognizes revenue when it is fully earned.

Deferred revenue and accrual accounting

When a company uses the accrual accounting Under this method, revenue is recognized as earned only when cash is received from a buyer and goods or services are delivered to the buyer. When a business records deferred revenue, it is because a buyer or customer has prepaid for a good or service that must be delivered at a later date.

Payment is considered a liability because there is always the possibility that the good or service may not be delivered or that the buyer may cancel the order. In either case, the company would reimburse the customer, unless other payment terms were explicitly stated in a signed contract.

Over time, when the product or service is delivered, the deferred revenue account is debited and the money credited to revenue. In other words, the revenue or sale is eventually recognized and therefore the money earned is no longer a liability. Each contract may stipulate different terms, so it is possible that no revenue can be recorded until all services or products have been delivered. In other words, payments collected from the customer would remain in deferred revenue until the customer has received what was due under the contract.

Deferred Revenue vs Deferred Expenses

Deferred expenses, like deferred revenue, involve the transfer of cash for something to be done in the future. Deferred revenue refers to money received for goods or services to be provided to customers in the future, while deferred expenses refers to money spent on obligations not yet met. Deferred expenses are expenses paid but not yet incurred. For example, rent payments are deferred expenses. Rent is prepaid for the future use of the property or land.

The deferred charge is recorded as an asset on the company’s balance sheet (for example, prepaid rent). The prepaid expense is classified as an asset. This account is debited, while the cash account is credited with the same amount. Once incurred, the expense is recognized in the income statement and the corresponding asset in the balance sheet is reduced.

Example

A country club collects annual dues from its customers totaling $240, which are billed immediately when a member signs up to join the club. Upon receipt of payment, the services have not yet been provided. The club would debit money and credit deferred revenue of $240.

At the end of the first month of membership, the club would recognize $20 in revenue by debiting the deferred revenue account and crediting the sales account. The golf club would continue to recognize $20 in revenue each month until the end of the year, when the balance in the deferred revenue account would be zero. On the annual income statement, the full amount of $240 would eventually be listed as revenue or sales.

The timing of revenue recognition and registration is not always straightforward. Accounting standards according to GAAPor generally accepted accounting principles, allow different methods of revenue recognition depending on the circumstances and the business sector of the business.

For example, an entrepreneur can use either the percent complete method or the completed contract method to recognize revenue. Under the percentage of completion method, the business would recognize revenue when certain milestones are achieved. Under the completed contract method, the company would not recognize a profit until the entire contract and its terms were fulfilled. Therefore, the contracts completed method results in lower revenue and higher deferred revenue than the percentage of completion method.

A company’s financial statements may appear different under one accounting method than another. Each method would result in a different amount recognized as deferred revenue, although the total amount of the financial transaction would not be different.

Conclusion

Deferred revenue is payments received by customers for goods or services that they expect to receive in the future. Until the service is performed or the good is delivered, the business is indebted to the customer, temporarily making the income a liability. Once earned, income is no longer deferred; it is realized and recognized as income.

Why is deferred revenue a liability?

Deferred revenue is revenue received but not yet earned. In other words, the payment received is for goods or services that will be delivered at some point in the future. As a result, the company owes the customer what was purchased and the funds can be recovered before delivery. Until earned, deferred revenue is a liability.

How is deferred revenue classified?

Deferred revenue is recorded as a liability on the balance sheet and the cash account (asset) on the balance sheet is increased by the amount received. Once income is earned, the liability account is reduced and the income account of the income statement is increased.

Are deferred revenues an operating liability?

Operating liabilities are amounts due resulting from the normal operations of a business, while non-operating liabilities are amounts due for things unrelated to the operations of a business. For example, mortgage payments and rents are non-operating liabilities. Deferred revenue is revenue recognized for services or goods that are part of its operations; therefore, deferred revenue is an operating liability.

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