Many types of businesses have to keep up with “deferred revenue,” which is money you have received but have not yet earned. For example, service-based businesses often require a deposit up front to start working. However, while in your bank account, that money is not “earned revenue” until the work has progressed. Until that point, the money is deferred or “unearned” revenue. As work goes on, the money will gradually move from your unearned revenue statements to your earned revenue statements. Of course, in the meantime, you need to be reporting it correctly.
What Is Deferred Revenue?
Deferred revenue, also known as “Unearned Revenues,” is how businesses classify revenue they have received that has not yet been earned. Customer deposits are an excellent example of unearned revenue. While your business may have the money in hand, you cannot count it on your earned income statement because it remains unearned. Therefore, it must be deferred to your balance sheet and reported as a liability.
Of course, as work takes place and you do begin to earn the money you hold, it should be transferred accordingly to your income statement. Some examples are often helpful in order to fully understand how deferred revenue may play a role in your business.
Examples of Deferred Revenue
Not all companies will deal with deferred revenue, but if you deliver services and require payment up-front, you most likely will.
For example, a company that offers website design services may give a customer a quote for $100,000 and says it will take 60 days to complete their project. They require a 25% deposit upfront before any work begins. The customer pays them that $25,000 deposit, but the company must track it as “deferred revenue” because they not begun working on the project yet. The company must recored a credit of $30,000 to their deferred revenues sheet and a debit of $30,000 to their cash sheet.
A couple of weeks later, the company reports to the client that they have completed 1/5 of the work, meaning that $20,000 (1/5 of the total amount) can be taken from the deposit and put on the income statement. The deferred revenues sheet will still show that $5,000 liability for the work they have been paid for but have yet to complete. Once they complete another $5,000 worth of work, they can move that money over as well.
Following that, the company will likely request another milestone deposit, perhaps again in the amount of $25,000. Again, they will not be able to count any of that money as income until it is earned. As you can guess, this same system can apply to many different types of businesses. Aside from website design, a construction business may also require an up-front deposit or even payment in full, and it must be counted as deferred revenue.
Why Deferred Revenue is a Liability
To understand exactly why deferred revenue should go in the books as a “liability” and not a profit, think about a much more widely recognized example. Insurance companies must deal with deferred revenue all the time. If they failed to do so, they’d likely end up spending a lot of money that they don’t actually have.
It is widely known that insurance companies accept pre-payment one, six, or even twelve months in advance. Say, for example, that a customer pays their 6-month policy in full for $1,200. All of that money must be reported as deferred revenue by the insurance company.
As each month passes, $200 can be moved to their earned income statement. The reason they cannot count all of it as “earned income” upfront is that, even though the customer has paid for the full policy, the customer could cancel their policy three months in and they would expect a prorated refund equal to the months they have not yet received coverage for, meaning the company must give them $600 back.
Tenants who make rent payments in advance, newspaper subscribers who pay in advance, and people who pay for software subscriptions in advance all give businesses a reason to use the deferred revenue accounting method.
To put it simply, unless the unearned money a customer gives you is completely non-refundable, you cannot count it as income until it is earned. This works to protect your company from spending money that you do not actually have because, just like an insurance company, while the money may be in your accounts, the customer could still essentially get it back should plans change.
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