According to fundamental accounting rules, a company should only record income once it has earned it, and it should only recognize costs once it has paid them.
Deferring recognition of revenues (or even costs) on your income statement over a specific time is referred to as deferral. As a substitute, you will record them as liabilities (or assets for costs) on your balance sheet accounts up until you earn or spend them. Then, later on, you’ll transfer them in pieces from the accounts on your balance sheet to the revenues (or costs) on your income statement.
Deferred revenue: what is it?
Deferred income is the term used to describe money you get in advance for goods or services you will provide. For instance, rent payments that you receive in advance or yearly subscription payments at the start of the year. This notion of delayed revenue implies a delay between order placement and delivery. As a result, you may also call it unearned income.
An example of a Deferred Revenue
For instance, a SaaS provider only reports a new customer’s $180 yearly membership cost as actual income in its accounts. Alternatively, it will initially show it as deferred revenue on its balance sheet and only report the $180 in revenue once it has collected the complete charge.
Deferred income—is it a liability?
Since you give the goods or services for free, technically, you can only count delayed revenues as income once you earn them. As a result, you cannot include these revenues in your income statement. Instead, you will list them as a liability on your balance sheet.
The mere fact that you have delayed money in your bank account does not guarantee that your customers will only request a refund in the future. Furthermore, severe regulations are limiting how to handle delayed income in particular businesses. For instance, to fulfill their fiduciary and ethical obligations, lawyers in the legal profession must deposit unearned fees into an IOLTA trust account. The consequences for non-compliance can be severe and can occasionally result in disbarment.
Deferred revenue is categorized as a liability for several other particular reasons, including:
- The client is owed money by the business, which is a liability. Therefore, the company must return the client’s money if the client requests a refund.
- Before it is generated, the corporation cannot recognize income. Revenue is only recognized under accounting guidance once all conditions for recognition have been met.
- It is the most cautious accounting strategy. Recognizing delayed revenue is a careful strategy that delays recording revenue rather than registering payment as soon as cash is received.
- The matching idea is followed here in its purest form. This approach aims to have both revenue and expense occur when it most nearly matches when the customer receives a benefit. It also increases the likelihood that a firm will record income and expense simultaneously.
FINAL INSIGHT
It’s also crucial to understand that until this money is produced, it shouldn’t be put into your future endeavors. A cautious method of determining income will provide you with a more accurate picture of the expansion of your business.
