What is Deferred Revenue (Deferred Income)?
Deferred revenue is the amount of income earned by the company for the goods sold or the services, however, the product or service delivery is still pending and examples include like advance premium received by the insurance companies for prepaid insurance policies, etc.
Thus, the Company reports it as a deferred revenue a liability than an asset until the time it delivers the products and services. It is also called as unearned revenue or deferred income.
A good example is that of a magazine subscription business where this revenue is a part of the business. Suppose a customer has subscribed for a monthly magazine subscription for one year and paid the whole amount. Let us assume that the customer pays $1200 for the 1-year magazine subscription. The customer will receive the first edition as soon as he pays and rests 11 editions every month as they are published. Thus, the Company will account for the cost of 11 magazines to be delivered in the future as unearned revenueUnearned RevenueUnearned revenue is the advance payment received by the firm for goods or services that have yet to be delivered. In other words, it comprises the amount received for the goods delivery that will take place at a future date. and as a deferred revenue liability. Now, as the Company starts delivering these magazines, the Company will realize them from unearned revenue liability to assets.
Other examples are:
- Service contracts like cleaning, housekeeping, etc.
- Insurance contracts
- Rent paid in advance
- Appliance services contracts like Air conditioners, water purifiers
- Tickets sold for events like sports events, concerts
Deferred Revenue on Balance Sheet
Typically, it is reported under current liabilitiesCurrent LiabilitiesCurrent Liabilities are the payables which are likely to settled within twelve months of reporting. They're usually salaries payable, expense payable, short term loans etc.. However, if the deferred income is not expected to be realized as actual revenue, then it can be reported as a long-term liability.
As we see from below, Salesforce.com deferred income is reported under the current liability section. It is $7094,705 in FY2018 and $5542802 in FY2017.
source: Salesforce SEC Filings
Deferred income in Salesforce consists of billing to customers for their subscription services. Most of the subscription and support services are issued with annual terms resulting in deferred income.
source: Salesforce SEC Filings
As we note from below, deferred income is reported as the largest in the January quarter, where most of the large enterprise accounts buy their subscription services. Please note that Salesforce follows the fiscal year with 31st January year-end.
source: Salesforce SEC Filings
Deferred Revenue Accounting
suppose a Company XYZ hires a housekeeping Company MNC to look after the cleaning and maintenance of its offices. The contract is for 12 months, and the Company XYZ pays $ 12,000 in advance for a year. Thus, at the start of the contract and time of payment, MNC has not yet earned $ 12,000 and will record it:
It is how Deferred Revenue on the Balance Sheet will look like
Now, after working for a month, MNC has earned $ 1000, i.e., it has provided its services to XYZ. Thus it will accrue its earning
Hence, $ 1000 of deferred income will be recognized as service revenue. Service revenue will, in turn, affect the Profit and Loss Account in the Shareholders Equity sectionShareholders Equity SectionShareholder’s equity is the residual interest of the shareholders in the company and is calculated as the difference between Assets and Liabilities. The Shareholders' Equity Statement on the balance sheet details the change in the value of shareholder's equity from the beginning to the end of an accounting period..
Deferred Revenue Recognition
Deferred income should be recognized when the Company has received payment in advance for a product/service to be delivered in the future. Such payments are not realized as revenue and do not affect the net profit or loss.
Deferred revenue recognition in a 2-way step:
- Increasing the cash and increasing deposit/deferred income on the liability side
- After the service is provided decreasing deposit/deferred income and increasing the revenue account
Similarly, this will impact the Cash flow statementCash Flow StatementStatement of Cash flow is a statement in financial accounting which reports the details about the cash generated and the cash outflow of the company during a particular accounting period under consideration from the different activities i.e., operating activities, investing activities and financing activities. of the Company:
- At the time of payment of the contract, realize all the cash received as cash from operating activitiesCash From Operating ActivitiesCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital..
- After the Company starts delivering the goods, no cash will be recorded for that particular contract.
Time to Realise deferred income
The time of reporting real revenue may depend on the contract terms and conditions. Some may record real revenue every month by debitDebitDebit is an entry in the books of accounts, which either increases the assets or decreases the liabilities. According to the double-entry system, the total debits should always be equal to the total credits. the deferred income partially while others may be required to do so after all the products and services are delivered. In such cases, this may lead to varied net profits/losses reported by the Company. The Company may have a period of high profits (when this revenue is realized as actual revenue), followed by periods of low profits.
Why do Companies Report deferred income?
While the Companies do not have a choice as per the accounting principlesAccounting PrinciplesAccounting principles are the set guidelines and rules issued by accounting standards like GAAP and IFRS for the companies to follow while recording and presenting the financial information in the books of accounts. to not to record deferred income, however, there are many advantages of doing so:
- As the deferred income of the Company is accrued and realized over a period of time, so are the revenues using the concept of deferred revenue accounting. The payments made by the customers can vary, and this will impact the financial performance of the Company. ShareholdersShareholdersA shareholder is an individual or an institution that owns one or more shares of stock in a public or a private corporation and, therefore, are the legal owners of the company. The ownership percentage depends on the number of shares they hold against the company's total shares. may not like such variable and volatile performance, hence revenue is reported when it is earned and not when it is paid.
- This safeguards investors’ interest as the Company cannot treat deferred income as its assets, which will overvalue its net worth. It provides that the Company has outstanding liabilities before it can realize its revenue and convert it into assets.
- It provides information that the Company owes and is liable to its customers. Although the Company has received the cash payment in advance; however, it is still at risk until the Company has performed its duties.
- Deferred income is used by the Company to finance its operations without pledging its assets or taking debt from banks and other financial institutions.
Deferred revenue accounting is a critical concept to avoid misreporting of assets and liabilities. It is majorly essential for Companies that get advance payments before it delivers its products and services. The bottom line is that once the Company receives money instead of goods and services to be done in the future, it should report it as deferred income liability. It will realize such revenue only after the goods and services are provided to the customers. If the Company realizes the revenue as it receives the money, it will overstate its sales. However, deferred income is essential to the Company as they help it to manage its finances and cover the cost of operating activitiesOperating ActivitiesOperating activities generate the majority of the company's cash flows since they are directly linked to the company's core business activities such as sales, distribution, and production..
Deferred Revenue (Income) Video
This article has been a guide to what is Deferred Revenues on Balance Sheet and its definition. Here we discuss how to account for deferred revenue and reasons why companies report deferred income. You may also have a look at these articles below on accounting basics –