Understanding the basics of accounting is vital to any business’s success. Under the accrual basis of accounting, recording deferred revenues and expenses can help match income and expenses to when they are earned or incurred. This helps business owners more accurately evaluate the income statement and understand the profitability of an accounting period. Below we dive into defining deferred revenue vs deferred expenses and how to account for both.
Deferred revenue is money received in advance for products or services that are going to be performed in the future. Rent payments received in advance or annual subscription payments received at the beginning of the year are common examples of deferred revenue.
Deferred expenses, also called prepaid expenses or accrued expenses, refer to expenses that have been paid but not yet incurred by the business. Common prepaid expenses may include monthly rent or insurance payments that have been paid in advance.
Accounting for Deferred Revenue
Since deferred revenues are not considered revenue until they are earned, they are not reported on the income statement. Instead they are reported on the balance sheet as a liability. As the income is earned, the liability is decreased and recognized as income.
Here is an example for a $1,000 payment for services that have not yet been performed: In this transaction, the Cash [Asset account] and the Unearned Revenue [Liability account] are increasing.
| Cash | $1,000 | |
| Unearned Revenue | $1,000 |
Once the services are performed, the income can be recognized with the following entry: This entry is decreasing the liability account and increasing revenue.
| Unearned Revenue | $1,000 | |
| Revenue | $1,000 |
Why is deferred revenue considered a liability? Because it is technically for goods or services still owed to your customers.
Accounting for Deferred Expenses
Like deferred revenues, deferred expenses are not reported on the income statement. Instead, they are recorded as an asset on the balance sheet until the expenses are incurred. As the expenses are incurred the asset is decreased and the expense is recorded on the income statement.
Below is an example of a journal entry for three months of rent, paid in advance. In this transaction, the Prepaid Rent [Asset account] is increasing, and Cash [Asset account] is decreasing.
| Prepaid Rent | $750 | |
| Cash | $750 |
Once one month of the expense has been incurred, the expense can be recognized with the following entry: Here we are decreasing our Prepaid Rent and increasing our Rent Expense on the income statement.
| Rent Expense | $250 | |
| Prepaid Rent | $250 |
Under the cash basis of accounting, deferred revenue and expenses are not recorded because income and expenses are recorded as the cash comes in or goes out. This makes the accounting easier, but isn’t so great for matching income and expenses. Learn more about choosing the accrual vs. cash basis method for income and expenses.
To discuss how we can best assist you and the associated fees, contact an Anders advisor below.
All Insights
Definition: Accounts Receivable [AR] is the proceeds or payment which the company will receive from its customers who have purchased its goods & services on credit. Usually the credit period is short ranging from few days to months or in some cases maybe a year.
Description: The word receivable refers to the payment not being realised. This means that the company must have extended a credit line to its customers. Usually, the company sells its goods and services both in cash as well as on credit.
When a company extends credit to the customer, the sale is realised when the invoice is generated, but the company extends a time period to the customers to pay the amount after some time. The time period could vary from 30-days to a few months.
Account Receivables [AR] are treated as current assets on the balance sheet. Let's understand AR with the help of an example. Suppose you are a manufacturer M/S XYZ Pvt Ltd and you manufacture tyres.
A customer gives you an order of Rs 1,00,000 for 100 tyres. Now, when the invoice is generated for that amount, sale is recorded, but to make the payment the company extends the credit period of 30-days to the customer.
Till that time the amount of Rs 1,00,000 becomes your account receivable because the customer will pay that amount before the period expires. If not, the company can charge a late fee or hand over the account to a collections department.
Once the payment is made, the cash segment in the balance sheet will increase by Rs 1,00,000, and the account receivable will be decreased by the same amount, because the customer has made the payment.
The amount of account receivable depends on the line of credit which the customer enjoys from the company. Usually, this is offered to customers who are frequent buyers.
PREV DEFINITION
NEXT DEFINITION