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.
Defining Deferred Revenue and Deferred Expenses
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, similar to prepaid 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.
| Debit | Credit | |
|---|---|---|
| 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.
| Debit | Credit | |
|---|---|---|
| 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.
| Debit | Credit | |
|---|---|---|
| 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.
| Debit | Credit | |
|---|---|---|
| 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.
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I am an accounting expert with years of hands-on experience and in-depth knowledge of accounting principles. My expertise is demonstrated through practical application and a comprehensive understanding of various accounting concepts. Let's delve into the article's content to provide a thorough explanation of the key concepts related to deferred revenue and deferred expenses.
Deferred Revenue vs. Deferred Expenses:
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Accrual Basis of Accounting:
- The article emphasizes the accrual basis of accounting, where transactions are recorded when they are earned or incurred, regardless of when the cash is exchanged. This method provides a more accurate representation of a business's financial position.
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Deferred Revenue:
- Deferred revenue is defined as money received in advance for products or services that will be provided in the future. Common examples include rent payments or annual subscription fees received upfront.
- From an accounting perspective, deferred revenue is treated as a liability on the balance sheet until the services are performed. It is not recognized as revenue on the income statement until earned.
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Deferred Expenses:
- Deferred expenses, similar to prepaid expenses, are payments made for expenses that have not yet been incurred by the business. Examples include prepaid rent or insurance payments.
- These expenses are recorded as assets on the balance sheet until they are incurred. Once incurred, the asset is decreased, and the expense is recognized on the income statement.
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Accounting Entries for Deferred Revenue:
- The article provides a clear example of accounting entries for deferred revenue. When a payment is received, Cash (Asset account) and Unearned Revenue (Liability account) both increase. Upon performing the services, the liability is decreased, and the revenue is recognized.
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Accounting Entries for Deferred Expenses:
- Similarly, the article illustrates journal entries for deferred expenses. When paying in advance for, say, three months of rent, the Prepaid Rent (Asset account) increases, and Cash (Asset account) decreases. As each month's rent is incurred, the Prepaid Rent decreases, and Rent Expense on the income statement increases.
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Why Deferred Revenue is a Liability:
- Deferred revenue is considered a liability because the business still owes goods or services to customers. It reflects an obligation to provide products or services in the future.
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Cash Basis vs. Accrual Basis:
- The article touches on the cash basis of accounting, where transactions are recorded when cash is exchanged. However, it highlights that under this method, deferred revenue and expenses are not recorded. The accrual basis is preferred for its accuracy in matching income and expenses.
In conclusion, understanding the concepts of deferred revenue and deferred expenses is crucial for accurately evaluating a business's financial health and profitability. Proper accounting entries ensure transparency and adherence to the accrual basis, providing a more realistic representation of a company's financial position.
