Any business owner worth their salt knows how important clean books and great, investment-ready accounting is to the health of their business. It’s the very heart of business growth! And this includes how to properly integrate deferred revenue into your accounting practices. In this blog, we’ll discuss what deferred revenue is, where exactly it sits on the balance sheet, and just why it’s so important for you and your business.
What is Deferred Revenue?
In a previous blog as part of our accounting terms series, we discussed what accrued expenses are but let’s quickly recap to set the tone for today. Accrued expenses – or accrued liabilities – are debts that a business accumulates for services or goods that have already been received but not yet billed. These are expenses that, even though they haven’t been billed or paid for, should still be entered into your accounts over the period of time the service or goods was delivered or performed, so that your business isn’t recording a huge payment in one month, for example.
Both accrued expenses and deferred revenue are part of accrual accounting. This is a type of accounting that can help you stay on top of the true financial picture of your business, matching your revenue and expenses to what’s being delivered, rather than simply knowing when money is paid in and out of the business. Accrual accounting allows you to map out the patterns and trends of profitability and growth in the business that might otherwise remain unknown when using cash accounting.
So, what’s deferred revenue? These are advance payments that you receive for services or goods that are to be delivered or performed at a future date. A customer or client has paid you in advance, so this is an unearned form of income. And deferred revenue would be recorded as a liability on your balance sheet because it’s unearned revenue and reflects that a service or good is owed to the customer or client.
Examples of Deferred Revenue
One of the most common examples of deferred revenue are subscription services. For example, an IT company offers a software as a monthly service but requires a yearly payment to subscribe to its service. And so, you’d be making the initial annual payment in advance of receiving this service, which would make this deferred revenue for the IT company providing the service. Each month, the IT company would earn back one-twelfth of this deferred revenue.
Another example is a magazine company offering a monthly subscription to their magazine requiring an initial payment for the year. Same as before, this would become deferred revenue for the magazine company, and they would earn back a portion of this revenue each month.
How Do You Account for Deferred Revenue and Why Is It Important?
Deferred revenue is not considered revenue until it’s earned back, and so because of this, this revenue isn’t reported on the income statement. Where it’s reported instead is on the balance sheet, and it’s recorded here as a liability.
It’s recorded as a liability because the revenue recognition process hasn’t been completed, and so it’s still an outstanding payment that could potentially change over time. For example, there’s still the possibility that the service or goods may not be delivered or that the customer might cancel their order. Whilst the service or goods are being delivered over time, the deferred revenue that has been accounted for as a liability on the balance sheet can be gradually debited and the money credited to revenue.
Deferred revenue is a significant part of accrual accounting and will allow you and your business to properly track both your finances and your delivered services/goods. Knowing what money is coming in and the relationship it has to your services/goods will make planning and mapping your finances that much easier as everything – including unearned income – is accounted for. Staying on top of both of these will mean that your accounts are always clean and organized!
Need Help Getting Your Books in Order?
Clean and organized records are the building blocks that every business needs in place in order to the levels of growth they have envisioned. And proper accrual accounting is at the heart of this foundation. If you don’t know where to start with accrual accounting for your business or just have a question (or two!), then Simple Startup is always on hand to help.