How to Record a Deferred Revenue Journal Entry
Understand and apply the full accounting cycle for deferred revenue, ensuring accurate financial statement presentation.
Deferred revenue is a common accounting concept for businesses that receive payments from customers before delivering goods or services. This financial practice involves careful record-keeping to ensure accurate reporting of a company’s financial position. Understanding how to properly record deferred revenue is important for any business operating under accrual accounting principles, as it directly impacts both the balance sheet and the income statement. It essentially represents a promise to a customer, reflecting an obligation that must be fulfilled in the future.
What is Deferred Revenue
Deferred revenue represents money a company receives in advance for products or services it has not yet delivered or performed. This advance payment creates a liability for the business, as it signifies an unfulfilled obligation to the customer. Under accrual accounting, revenue is recognized when it is earned, not when cash is received. Therefore, until the goods or services are provided, the payment cannot be counted as earned revenue.
This liability commonly arises in various business scenarios. Examples include annual subscriptions for software or publications, where customers pay upfront for a full year of service. Gift card sales also create deferred revenue, as the company receives cash but earns revenue only when the card is redeemed. Retainers for future work or upfront payments for multi-month service contracts, such as a gym membership, also result in deferred revenue until services are rendered.
Deferred revenue differs from earned revenue because the company still owes a product or service to the customer. It is initially recorded on the balance sheet as a liability, typically a current liability if the obligation is expected to be fulfilled within one year.
Recording the Initial Receipt of Cash
When a business first receives cash for goods or services that have not yet been delivered, a specific journal entry is required. This initial transaction reflects the increase in the company’s cash assets and the creation of a liability. The cash received is not immediately recognized as revenue because the earning process has not yet been completed.
The journal entry involves debiting the Cash account and crediting the Deferred Revenue account. For example, if a company receives $1,200 for a one-year service contract paid upfront, the entry would be a debit to Cash for $1,200 and a credit to Deferred Revenue for $1,200.
At this stage, there is no impact on the income statement. The receipt of cash only signifies an increase in assets and an equivalent increase in liabilities, maintaining the balance sheet equation (Assets = Liabilities + Equity). The Deferred Revenue account acts as a placeholder, indicating the company’s obligation to provide the promised goods or services in the future.
Recognizing Revenue Over Time
As the business fulfills its obligation by delivering the goods or performing the services, the deferred revenue liability decreases, and earned revenue is recognized. This process occurs over time or upon the completion of the service, aligning with accrual accounting principles. Revenue is earned when the company has substantially completed its performance obligation to the customer.
The journal entry to recognize earned revenue involves debiting the Deferred Revenue account and crediting the appropriate Revenue account. For instance, if a $1,200 annual service contract is earned evenly over 12 months, $100 of deferred revenue would be recognized as earned revenue each month.
The entry would be a debit to Deferred Revenue for $100 and a credit to Service Revenue for $100. This entry reduces the liability on the balance sheet and increases revenue on the income statement. This ongoing adjustment ensures that revenue is matched to the period in which it is actually earned. The balance in the Deferred Revenue account will gradually decrease to zero as the company completely fulfills its contractual obligations.
Applying Deferred Revenue Entries
Consider a software company that sells an annual subscription for $600, paid upfront by the customer on January 1. The company provides access to its software services throughout the year.
Upon receiving the initial $600 payment on January 1, the company would record the following journal entry: Debit Cash for $600 and Credit Deferred Revenue for $600. The $600 sits as a liability on the balance sheet, representing the company’s obligation to deliver 12 months of software service.
As each month passes and the software service is provided, the company earns a portion of that $600. Since the subscription is for 12 months, $50 ($600 divided by 12 months) of revenue is earned each month. At the end of January, the company would make an adjusting entry: Debit Deferred Revenue for $50 and Credit Subscription Revenue for $50.
This same adjusting entry would be repeated at the end of each subsequent month for the remaining 11 months. By the end of December, the entire $600 initially recorded as deferred revenue will have been recognized as earned subscription revenue.