Any business completes a sale when it delivers the goods or services and receives payment for them. The delivery and payment timing might differ. The business model may require advance booking, as in a music event, or require annual subscriptions, as in a newspaper or software. Sometimes, customers pay retainers to lawyers, which the lawyers deduct from their fees and legal expenses. Such different payment and delivery models need deferred revenue.
What is Deferred Revenue?
Deferred revenue occurs when a company receives payment in advance of delivering products or services. It is also called unearned revenue, as the business must earn it by delivering the product. The treatment of deferred revenue in business accounting differs from a normal sale, as liabilities and revenue recognition come into play, complicating the transaction.
Liability: The company is liable to deliver the service/product or refund the money if deliverables can’t be met. That refund comes from the deferred revenue balance that is separately reported in the balance sheet.
Revenue Recognition: Accrual accounting says revenue should be recognized when the product/service is delivered. For instance, Jerry made an advance payment of $12,000 for 12 months to Company X. X cannot recognize the entire payment as revenue, as it has not yet delivered the service. It will report $1,000 in revenue every month as deliveries are made.
How Deferred Revenue Works
In accrual accounting, revenue recognition depends on the time of delivery and not the time of payment. To identify which revenue to recognize, you have to refer to the contract between the company and the client and understand the promised deliverables and payment terms.
Based on the contract, you can determine whether the promised delivery has been made and recognize the revenue at the agreed price. Hence, businesses should maintain detailed records of all contracts, customer payments, and performance obligations to ensure the correct revenue amount is recognized at the right time. This might look like extra work, but these documents can save you from significant penalties if you face a Canada Revenue Agency (CRA) audit in the future.
How to Track and Report Deferred Revenue
Let’s understand the reporting of deferred revenue with an example. For instance, you paid an annual broadband subscription of $1,200. The service provider has a monthly billing cycle. So, the provider will realize a revenue of $100 each month and deduct that amount from the deferred revenue balance.
In the first month, revenue of $100 will appear on the income statement, and deferred revenue of $1,100 will appear in the current liabilities segment of the balance sheet. If the revenue is deferred beyond 12 months, it will be reported as non-current liabilities. As broadband service is delivered, revenue will be recognized, and the deferred revenue balance will be reduced.
This separation clearly demarcates what is earned and what is owed to the customer. Suppose a client paid for three months of physiotherapy sessions in advance, and the therapist is absent for a month due to personal reasons. In this scenario, where the therapist cancelled a month’s worth of sessions, the revenue won’t be recognized, and the deferred revenue liability will remain unchanged. That means the therapist has to either deliver the sessions or reimburse the money unless the contract terms say otherwise.
Why do Companies Use Deferred Revenue?
Companies use deferred revenue to maintain the integrity of financial statements. The main objective offinancial statements is to show the actual business operations as of that date. If the business has completed its end of the deal, it will appear in the income statement. Whatever is owed and owned will appear on the balance sheet and become a part of the business valuation.
Entries like deferred revenue provide transparency in the financial statements and show the business’s valuation, real profitability, and tax liability.
Valuation: The deferred revenue balance shows the customer loyalty a business enjoys. It brings visibility in future revenue, shows how many deliverables are pending, and helps the business plan their inventory and expenses accordingly. Investors consider this amount when valuing the business as they are assured of this revenue.
Profitability: Accrual accounting uses deferred revenue to determine how much profit a company generates from sales, regardless of when payments are processed. Let’s consider the cash accounting method, where transactions are recorded based on the payment timeline and not the delivery timeline.
Maya has a newsletter to which 100 people have subscribed at $75 per annum. Her monthly newsletter costs $350. Assuming all the subscribers paid $7,500 in total in January. In cash accounting, her January revenue will be recorded at $7,500, and operating expenses will be $350, resulting in a net profit of $7,150. For the remaining months, she will report a $350 loss. This does not give the true picture of profitability. Hence, deferred revenue is used. wherein the $7,500 in revenue is spread over 12 months, yielding a monthly revenue of $625. When Maya deducts $350 in operating expenses, her monthly net profit is $275, and profitability is 44% of revenue. Deferred revenue normalizes your profits, removing the extreme volatility of cash transactions.
Tax liability: In deferred revenue, you receive cash in advance, but you pay tax only on the realized revenue, which helps you plan resource allocation more efficiently.
Deferred revenue is a key metric for stakeholders, from chief financial officers (CFOs) to investors, as it helps plan expenses, forecast, and make strategic business decisions. However, deferred transactions are complex and prone to calculation errors. A professional accountant is well-versed in reporting such transactions in a transparent and compliant way.
Contact Black and Gill LLP in West Toronto to Help You with Your Accounting Needs
Talk to a professional accountant to help you navigate the complexities of accrual accounting and report complex standards in a compliant manner. At Black and Gill LLP, our accountants and bookkeepers can provide services such as preparing financial statements and managing cash flows. To learn more about how Black and Gill LLP can provide you with the best accounting and bookkeeping services, contact us online or call us at 416-477-7681.