Imagine a see-saw on a playground: it’s all about balance. Without it, one side crashes down while the other shoots up. Now, imagine that see-saw represents your company’s financial health. Still seem like child’s play? Not quite!
Just like the delicate balance of a see-saw, understanding and applying accounting principles like ‘deferral’ can mean the difference between smooth financial operations and a chaotic financial see-saw. So, buckle up as we dive deep into the world of deferrals in accounting, providing clarity for this crucial concept that impacts businesses big and small.
What is deferral in accounting?
In simple terms, deferral refers to delaying the recognition of certain transactions. It’s like saying, “Hold on, we’ve received this money or paid this expense, but let’s not record it as revenue or expense yet.” However, it wouldn’t be appropriate not to record anything at all, because money is still trading hands.
Accounting principles require the revenues and expenses are recorded when they are incurred. The revenue recognition principle requires that revenue is recorded when the product is sold or the service is provided. When customers prepay for products or services they won’t receive until later, the payment is recorded as deferred revenue on the balance sheet rather than sales or revenue on the income statement.
When customers pay in advance for products or services they won’t receive until later, this payment is recorded as deferred revenue on the balance sheet. The payment is not immediately recognized as sales or revenue on the income statement. This ensures that revenues and expenses are matched to the period when they occur, providing a more accurate picture of a company’s financial performance.
To put it in perspective, let’s consider a magazine subscription. When a customer pays for a year’s subscription, the publisher can’t record the full payment as revenue immediately because the magazines have not yet been delivered. This scenario is a classic example of deferral.
The publisher will instead record the payment as deferred revenue, a liability, on the balance sheet. As each magazine is delivered over the year, an appropriate portion of the deferred revenue is then recognized as revenue on the income statement. This process continues until the subscription period ends and all the deferred revenue has been recognised as earned revenue.
This method ensures the revenue is matched with the corresponding expense (the cost of producing and delivering the magazines), aligning with the matching principle in accounting and providing a more accurate depiction of the publisher’s financial performance.
Why is deferred revenue a liability?
Deferred revenue, often referred to as unearned revenue, is a unique accounting concept that initially seems at odds with typical business thinking. It represents the money received by a company for a product or service that it has yet to deliver to the customer. So, despite the influx of cash, it isn’t yet recorded as revenue. Why is that?
The answer lies in the nature of the company’s obligations. When a company receives payment in advance, it’s essentially making a promise to the customer: the promise of a future good or service. At this stage, the company owes the customer that product or service, much like how it would owe money in the case of a loan. This obligation, this “debt” to the customer, is why deferred revenue is categorized as a liability.
It might be easier to think of deferred revenue as “prepaid” revenue. Just as a prepaid expense is an asset that turns into an expense as the benefit is used up, deferred revenue is a liability that turns into income as the promised good or service is delivered.
As the company fulfills its obligation—whether that’s shipping a product, providing a service, or anything else it was paid to do—it gradually reduces the liability on its balance sheet. Correspondingly, it recognises that amount as revenue on its income statement. By the time the company has completely fulfilled its obligation, the deferred revenue balance will have been fully shifted to earned revenue.
Deferred revenue is a liability on the balance sheet. A deferred revenue journal entry involves debiting (increasing) the cash account and crediting (increasing) the deferred revenue account when payment is received. As the service is provided, deferred revenue is debited, and revenue is credited.
Imagine you’re a software company, and you’ve just sold a one-year subscription to a customer who pays the entire fee upfront. While you’ve received the money, you haven’t provided the year’s worth of service yet. You’re essentially “in debt” to your customer for that service. That “debt” or obligation is what makes deferred revenue a liability. As you deliver the service over the year, you gradually reduce the liability and recognise it as revenue.
Getting to grips with the deferral adjusting entry
A deferral adjusting entry is made at the end of an accounting period to move the deferred amounts to the right accounts. For example, if you have a deferred revenue liability for a 6-month project on your balance sheet, you’d adjust it monthly to move a portion (1/6th each month) from deferred revenue to earned revenue.
Deferred payment: A special case of deferral
A deferred payment is a financial arrangement where a customer is allowed to pay for goods or services at a later date rather than at the point of sale. It’s a financial agreement that provides the buyer with the benefit of time to gather resources or better manage cash flow. This time-lapse could range from a few months to several years, depending on the terms of the agreement.
To help visualise this, think about purchasing a stylish new sofa for your living room. The furniture store allows you to take the sofa home today, but they don’t require immediate payment. Instead, you agree to pay for the sofa in 6 months. This arrangement is a prime example of a deferred payment.
Deferred payment can be a win-win for both parties. The buyer gets the needed goods or services immediately and the seller might secure a sale they otherwise wouldn’t, possibly charging interest or a higher price in return for the deferment.
However, it’s crucial to distinguish deferred payment from deferred revenue. The key difference lies in the perspective and the transaction’s nature. Deferred payment is from the buyer’s viewpoint—it’s about delaying the payment for goods or services. On the other hand, deferred revenue is from the seller’s perspective—it involves receiving payment for goods or services that will be delivered or performed in the future.
For instance, if the furniture store were to offer a yearly maintenance service for your new sofa, and you paid the full annual fee upfront, the store would record this as deferred revenue. Although they’ve received the money, they can’t recognize it as revenue until they’ve actually performed the maintenance services over the year. As each service is provided, a portion of the deferred revenue would be recognized as earned revenue.
So while both involve a delay, deferred payment deals with the timing of the payment, and deferred revenue pertains to the timing of revenue recognition.
Understanding Accrual vs Deferral
Accrual and deferral are two sides of the same coin, each addressing a different aspect of revenue and expense recognition. They are foundational concepts in accounting that ensure financial statements accurately reflect a company’s financial position.
Accrual accounting recognizes revenues and expenses as they’re earned or incurred, regardless of when the actual cash is exchanged. For example, if a company provides a service in June but doesn’t receive payment until July, the revenue would still be recorded in June under accrual accounting. Similarly, if the company receives a bill for utilities in June but doesn’t pay it until July, the expense would be recognized in June. The focus here is on the earning of revenue or the incurring of expense, not the movement of cash.
Let’s consider an example to illustrate deferral:
Suppose you prepay for a year’s worth of insurance in January. Even though you’ve paid the cash upfront, you wouldn’t recognize the entire amount as an expense in January under the deferral principle. This is because you haven’t yet received the full year’s worth of insurance coverage. Instead, you would record the payment as a prepaid expense—an asset—and then gradually recognize a portion of it as an expense each month. By the end of the year, you would have recognised the entire prepaid amount as an insurance expense.
Deferred revenue vs accounts receivable: Clearing the confusion
Accounts receivable is an example of accrual accounting. When a company has an account receivable from a customer, they’ve already provided the goods or services and are awaiting payment from the customer. Accounts receivable is money owed to the company for goods or services already provided where deferred revenue is payment received for goods or services still owing. An account receivable is an asset, and deferred revenue is a liability.
Final thoughts on deferral in accounting
Understanding deferral in accounting is essential for financial management. From recognizing deferred revenue on your balance sheet to differentiating between deferred revenue and accounts receivable, these concepts are vital for tracking cash flow while staying in line with accounting principles.