What’s deferred revenue?
If you're following Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) for accrual accounting, you're calculating and recording deferred revenue. When you record the sale, you are entering into a contract with that customer to deliver goods or a service in the future. This is a deferred revenue liability. Contrary to what the name implies, Deferred Revenue is not actual revenue yet.
How to record deferred revenue?
Whena customer initiates their order, a liability of Deferred Revenue is createdand an asset of Accounts Receivable is also recorded to reflect the expectationof future cash to be received. Because the company has not fulfilled itsobligation of merchandise, an exercise machine, or their first box in an annualsubscription the company has not earned any revenue just yet.
Inthe US, ASC 606 requires GAAP compliant companies to record revenue whileadhering to the matching principle and following the 5-step process outlined bythe FASB in the guidance. Revenue can be recognized when each of thesteps below have been completed:
- Identify the contract or contracts with the customer
- Identify the contract's specific performance obligations
- Determine the transaction price
- Allocate the transaction price to performance obligations
- Recognize revenue when you've fulfilled each performanceobligation
Why tracking and recording Deferred Revenue is important?
Recognizingrevenue in the period that it was earned versus at time of sale can have ameaningful impact on the amount shown on the income statement.
- In businesses where there’s a delay between the order and the timeof fulfillment or that sell products or services that are fulfilled over longperiods of time (i.e. annual subscriptions), the difference can be significant.
- We’ve also seen discrepancies with businesses that have a highcancellation rate. In this instance, if they’ve recognized the revenue uponsale and not upon fulfillment, they’ve overstated their revenue and then needto adjust out those orders that were cancelled and never fulfilled.
Deferredrevenue does represent a liability in that the business has yet to deliver theproduct or service. For practical purposes by not recording deferred revenuethere could be an obligation with real costs that need to be incurred in thefuture. For companies that ship physical goods the future cost could includethe actual cost of the product to the business along with shipping andfulfillment costs to deliver it.
On arelated note, the matching principle in accounting says that you need to matchexpenses in the same period that the corresponding revenue was earned. From apractical perspective when you look at an income statement you can easily seethe revenue that was truly earned in the period and the corresponding costswith that sale. By not recognizing revenue based on delivery and matchingcosts, it is difficult to understand the true cost of providing that good orservice. Without a true understanding of revenue and cost of goods sold — orgross margin, a business may be missing critical opportunities to improve its profitability.
How does Blue Onion help?
Blue Onion can make Deferred Revenue easier to track and calculate. Not sure whereto start? Book a free consultation with our Accounting Expert team and we will show you how Blue Onion helps leading brands reduce manual data processing and calculations in their workflow.
Disclaimer: The information provided in this article is intended as general guidance only and is not intended to be nor should it be considered legal or financial advice. You should consult with your CPA to review your business' specific accounting issues and challenges.
