Most small business owners are familiar with the concept of revenues, which is essentially the total sales of their product or service, to customers and clients, prior to deducting any costs. Revenues are a crucial component of business’ profit and loss statement and it is essential that they are accurate so that the business owners may effectively analyze the profitability of their businesses. Additionally there are third parties for which the accuracy of the revenues, and corresponding financial statements, is essential for effective decision making. Third parties include tax authorities, banks, partners and key employees (on which remuneration/bonuses might be based).
At first glance the calculation of total sales/revenues seems fairly straightforward. Add up your total sales (or ideally have your accounting software do it for you) and voila – you have your gross sales. There are, however, several types of adjustments that need to be made depending on the nature of the sale, including any amounts that might be construed as deferred revenues. Essentially (and quite simply) deferred revenues represent sales that are invoiced to customers now for goods or services to be provided at a later date. Revenue recognition principles dictate that, unless the sale has actually occurred, the revenue cannot be recognized. In other words these amounts must be reflected as deferred revenues. Once the product or service has been delivered or performed, the deferred revenue is then considered to be an actual sale/revenue. To a non-accountant, this can sound like a lot of mumbo jumbo. The examples of deferred revenue below should help illustrate the concept more clearly:
- A rental company might receive the final two months’ rent of the lease term up front as a condition of the lease. In this case, these amounts have not yet been earned as the service (occupying the rented premises for the last two months of the lease) has not yet been rendered. The rental company will show these amounts as deferred revenue until the lease term is over. Note that if the rental company had shown the revenue right away it would overstate their revenue while the revenue for the final two months of the lease would be understated.
- Law firms regularly receive retainers for future services to be rendered. Again in this case, since the services have not been rendered, however monies have been received this needs to be shown as deferred revenue until the deposit (retainer) received is offset against specific invoices.
- Subscription services are often paid for annually, in advance. Companies offering virus protection services and/or movie subscription services like Netflix will charge you for the whole year (sometimes offering a discount) but are required to provide service until the subscription period is over. Revenues received that relate to the future must then be deferred until they are earned.
Accounting for Deferred Revenue:
The fun part of deferring your revenue is figuring out how to account for it (sarcasm font?). For each of the above examples, journal entries are as follows:
On inception of lease
Cr. Deferred Rental Revenue
Conclusion of Lease:
Dr. Deferred Rental Revenue
Cr. Rental Revenue
The deferred rental revenue is shown on the liabilities section of the balance. This is because until the service is performed, the amount is effectively owed to the customer. If the company were to cease operations today, amounts for services not performed would have to be repaid.
The Importance of Deferred Revenue for Small Businesses
Deferring revenue allows businesses to reflect the revenues in the period in which they occur. This ensures that the revenues are more accurately matched to their expenses and that sales and net income are not overstated. Smoothing out your revenues, by removing deferred revenues, allows for more accurate analysis of financial metrics and helps to avoid wild swings in revenues. Finally, the period of deferral, allows for a reduction in income taxes by reducing your net income. Generally accepted accounting principles (GAAP) (and tax authorities) requires that you accurately calculate and reflect these amounts with the aim of improving accuracy and the quality of your financial statements.