Why is Deferred Revenue Treated as a Liability?

Deferred income is fee acquired from a buyer earlier than a services or products has been delivered; nevertheless, the fee isn’t but counted as income. Deferred income, which can be known as unearned income, is listed as a legal responsibility on the stability sheet as a result of, beneath accrual accounting, the income recognition course of has not been accomplished. 

Deferred Income and Accrual Accounting 

When an organization makes use of the accrual accounting methodology, income is barely acknowledged as earned when cash is acquired from a purchaser and the products or companies are delivered to the client. When an organization accrues deferred income, it’s as a result of a purchaser or buyer paid upfront for an excellent or service that’s to be delivered at some future date.

The fee is taken into account a legal responsibility as a result of there’s nonetheless the likelihood that the great or service could not be delivered or the client may cancel the order. In both case, the firm would repay the shopper, until different fee phrases had been explicitly acknowledged in a signed contract.

Over time, when the services or products is delivered, the deferred income account is debited and the cash credited to income. In different phrases, the income or sale is lastly acknowledged and, subsequently, the cash earned is now not a legal responsibility. Every contract can stipulate totally different phrases, whereby it is attainable that no income may be recorded till all the companies or merchandise have been delivered. In different phrases, the funds collected from the shopper would stay in deferred income till the shopper has acquired what was due in accordance with the contract. 

Instance 

A rustic membership collects annual dues from its prospects totaling $240, which is charged instantly when a member indicators as much as be a part of the membership. Upon receipt of the fee, the companies have but to be offered. The membership would debit money and credit score deferred income for $240.

On the finish of the primary month into the membership, the membership would acknowledge $20 in income by debiting the deferred income account and crediting the gross sales account. The golf membership would proceed to acknowledge $20 in income every month till the top of the 12 months when the deferred income account stability could be zero. On the annual revenue assertion, the total quantity of $240 could be lastly listed as income or gross sales.   

The timing of recognizing income and recording isn’t at all times simple. Accounting requirements in accordance with GAAP, or Typically Accepted Accounting Rules, enable for totally different strategies of income recognition relying on the circumstances and the corporate’s trade.

For instance, a contractor may use both the percentage-of-completion methodology or the accomplished contract methodology to acknowledge income. Below the percentage-of-completion methodology, the corporate would acknowledge income as sure milestones are met. Below the completed-contract methodology, the corporate would not acknowledge any revenue till your complete contract, and its phrases had been fulfilled. Because of this, the completed-contract methodology leads to decrease revenues and better deferred income than the percentage-of-completion methodology.

An organization’s monetary statements may seem totally different utilizing one accounting methodology versus one other. Every methodology would end in a totally different quantity recorded as deferred income, regardless of the whole quantity of the monetary transaction being no totally different. 

Backside Line

Deferred revenues are the funds acquired by prospects for items or companies they count on to obtain sooner or later. Till the service is carried out or the great is delivered, the corporate is indebted to the shopper, making the income briefly a legal responsibility. As soon as earned, the income is now not deferred; it’s realized and counted as income.