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Overview of Deffered Revenue

Posted on April 26th, 2013 by Sanjit Anand ||Email This Post Email This Post

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Under Generally Accepted Accounting Principles (GAAP), deferred revenue, sometimes called unearned revenue.

Deferred revenue is a liability that is created when monies are received by a company for goods and services not yet provided.

dgreybarrow What is the deferred revenue?

Deferred revenue is a liability that is created when monies are received by a company for goods and services not yet provided.

Revenue will be recognized, and the deferred revenue liability eliminated, when the services are performed.

Deferred revenue stems from the accounting concept of revenue recognition, under which revenues are recognized only when the earnings process is complete. If funds are received and no goods or services have yet been provided, the process is not complete; thus revenue cannot be recognized, and a deferred revenue liability is recorded.

Specifically, the deferred revenue account is credited, and cash (or otherassets) are debited. Please take a note deferred revenue is recorded in specific industries under particular circumstances.

dgreybarrow Deferred Revenue Example

Like many subscription businesses, A internet Hosting company offers a plan to pay upfront for whole year.

Since deferred revenue represents the value of the services that are left to be delivered at a point in time, if you purchased the annual plan, $2400 would be added to both the cash account of the balance sheet and the deferred revenue line. Every month $200.00 would be moved out of deferred revenue and reported as revenue on the income statement.

dgreybarrowUnderstand why you need to defer revenue.

Why can’t you just record the revenue when you actually receive the cash payment? By doing so , this would violate the principles of accrual-based accounting.

There are 2 principles which provide the foundation for accrual accounting.

  1. The first is the matching principle. Under the matching principle, revenues and expenses that correspond to each other must be recorded in the same accounting period. Using the insurance example above, you cannot recognize all the revenue in January, because there will be expenses associated with that insurance coverage incurred throughout the year. These expenses must be matched with their corresponding revenues.
  2. The second is the revenue recognition principle. This principle dictates that revenues should only be recorded when they are both realized (or realizable) and earned. “Realized” revenues are those for which a claim to cash has been received, and “earned” revenues are those for which a good or service has been rendered.

The implication, then, is that you cannot simply record a revenue whenever cash is paid to your company. If, for example, a client is prepaying for a continuing service, then you cannot recognize that payment as revenue until you actually render the service. Until then, the payment represents a liability, or an obligation to the client. This makes sense to you.

dgreybarrow Governing Rule

For revenue to be recognized (earned), SEC have SAB 101/104 sets four key conditions that must be met:

  1. Persuasive evidence of an arrangement exists,
  2. Delivery has occurred or services have been rendered,
  3. The seller’s price to the buyer is fixed or determinable, and
  4. Collectability is reasonably assured

dgreybarrow Understanding the Deferred Revenue Accounting Process

You can create and send invoices for products or services that you will deliver in the future or over a range of time.

Invoice details:

  • Bill line amount: 6000.00 USD.
  • Invoicing Rule = Bill in Advance
  • Invoice Date 2-DEC-12
  • GL Date 2-DEC-12
  • Accounting Rule:Type: Accounting, Fixed Duration
  • Period : Monthly
  • Number of Periods : 6

Here is accounting Posting
Deffered Rev Accounting

dgreybarrow Finally

Keep in mind that deferred revenue generally means that cash has been received by the seller, so the remaining concern is determining when the cash is recognized as earned revenue. Within GAAP, there are multiple methods that can be used to recognize revenue. Depending upon which method is chosen, the financial statements may look drastically different even though economic reality remains the same.

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