Do customers pay for the goods or services purchased before delivering them? The answer is a big YES. If so, the need for knowing about deferred revenue arises. In common parlance, it is called unearned revenue. The revenue becomes unearned when the company receives advance payment for a product/service which has not been delivered yet.
Receiving a payment is generally considered an asset. However, prepayments are liabilities as they have not been earned yet, and the business still owes the delivery of a product or service to the customer.
It is shown on the liabilities side of the balance sheet. But the deferred revenue turns into earned revenue only after the customers’ receipt of goods or services.
What is deferred revenue?
The customers make the cash or cheque payment for the goods or services that haven’t been delivered to them yet. Deferred revenue is common in subscription-based revenue service providers.
For instance, big houses like Netflix, Amazon Prime Video recognizes the subscription revenue on a deferred basis. It may be sometimes recognized as Unearned revenue, Deferred Income, or Unearned Income.
The deferred revenue starts getting realized into revenue as the goods or services get delivered to the customers. Deferred revenue is recorded due to the use of the accrual and matching system of accounting by business firms.
The accounting for the deferred arises due to the accrual system of accounting and accounting standards on revenue recognition.
Briefly speaking, as per the accrual accounting system, financial transactions are recorded as and when they occur. The accounting standard AS 9 on revenue recognition provides criteria for recording revenue as follows:
- The company must have delivered the products or provided the services in full before recognizing the revenue. Else it can only estimate and book the revenue for the part delivered.
- The company must be certain that it will be able to collect the revenue
- The price of the goods or services are fixed or can be determined easily.
Since the above conditions are not fulfilled in case of prepayments made before receipt of goods or services, revenue is not recognized in full, and it is recognized periodically as and when the revenue becomes due.
IFRS 15 on Revenue Recognition states that” recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.”
Recording deferred revenue
As the goods or services are delivered over time, it is gradually recognized as revenue in the income statement over a period when the revenue gets earned at given intervals of time.
The proportionate earned revenue is recorded as earned revenue in the income statement. The remaining portion of revenue is recorded as deferred revenue on the liability side of the balance sheet.
Examples of such revenue are advance rent payments, prepaid subscription fees of newspapers, streaming services, or prepaid insurance.
The entries to record such revenue are as follows:
When cash is received:
| Date | Particulars | Debit ($) | Credit ($) |
| Cash Account | XXX | ||
| Deferred revenue | XXX | ||
| (To record the receipt) |
At the end of each month:
| Date | Particulars | Debit ($) | Credit ($) |
| Deferred revenue | XXX | ||
| Revenue | XXX | ||
| (To record revenue recognition) |
Let us understand the process of recording deferred revenue with an example:
Netflix provides a 1-year subscription package at $3,000. The customer opts for a yearly package. Upon receipt of the payment of one 1year from the customer, Netflix debits entry to cash and credits entry to deferred revenue of $3,000.
As the months pass, the company recognizes the revenue of $250 each month by debiting deferred revenue account and crediting revenue account. By the end of the year, the whole balance of deferred revenue is reduced to 0, and the revenue account increases by the concerned revenue. This can be recorded as follows:
Journal entries:
In the beginning,
| Date | Particulars | Debit ($) | Credit ($) |
| Cash Account | 3000 | ||
| Deferred revenue | 3000 | ||
| (To record the receipt) |
At the end of each month:
| Date | Particulars | Debit ($) | Credit ($) |
| Deferred revenue | 250 | ||
| Revenue | 250 | ||
| (To record revenue recognition) |
Finally, the whole revenue would be recognized as revenue at the end of the year and will be recorded as:
| Date | Particulars | Debit ($) | Credit ($) |
| Deferred revenue | 3000 | ||
| Revenue | 3000 | ||
| (To record revenue recognition) |
The amount of $3000 would be recorded as revenue in the income statement under Subscription Revenue. The adjusting entry would be:
| Date | Particulars | Debit ($) | Credit ($) |
| Revenue | 3000 | ||
| Profit & loss account | 3000 | ||
| (To record transfer of revenue to P/L Statement) |
The concept of deferred revenue arises prominently in the construction contracts where revenue is recognized based on the percentage of completion of work. Under this method, the Company recognizes revenue as certain milestones are met.
