In this post we will look at the impact of deferred revenue on a company’s financial statements. As you work through this post keep in mind that deferred revenue, which is also referred to as unearned revenue, represents a liability to the company.
A visual representation of how deferred revenue flows through the three financial statements can be found at the bottom of this post. Please refer to the image for the sequence that follows:
(Note: I have always found it helpful to havean image of the accounting equationavailable as a reference while working through these exercises.)
MONTHONE:
The company invoices a customer for a research report that requires payment in Month 3, and will be delivered to the customer in Month 4.
Journal Entry:
Dr: Accounts Receivable $100
Cr: Deferred Revenue $100
Note: In this example no cash is received in Month 1. In many deferred revenue examples cash is received in the first period. In this case you would simply debit cash and credit the deferred revenue account in the first accounting period for the sum received.
Balance Sheet:Accounts receivable (asset) increases by $100, and deferred revenue (liability) increases by $100.
Cash Flow Statement:Since we have an equal increase in both an asset and a liability, the impact to cash is zero.
MONTHTWO:
Nothing happens. You can see that there are no cash adjustments on the CF statement.
MONTHTHREE:
In month three the customer pays. You will notice, however, that the report has not been delivered. So while the company has received cash in this period it willnotrecord revenue.
Journal Entry:
Dr: Cash $100
Cr: Accounts Receivable $100
Balance Sheet:The accounts receivable balance is reduced by the amount of cash received, in this case $100. Deferred revenue remains a liability because the company has not yet delivered the product.
Cash Flow Statement:The cash flow statement will take the difference in accounts receivable from the balance sheet, in this case creating a cash inflow of $100.
MONTHFOUR:
In month four the research report is delivered and revenue is recorded.
Journal Entry:
Dr: Deferred Revenue $100
Cr: Revenue $100
Income Statement:The revenue associated with the contract flows through the income statement and (assuming it was priced appropriately) positive Net Income (NI in the image below).
Balance Sheet:Deferred revenue is reduced to zero.Stockholder’s equity (retained earnings specifically) grows by this amount of net income.
Cash Flow Statement:At the top of the cash flow statement, net income grows by the amount associated with the sale of this research report. Deferred revenue, which was reduced from $100 to $0 on the balance sheet reduces cash flow by $100. The impact to cash flow for the period is -$100 + NI.(Note: because we do not show the cost of producing the report in this example, it can be assumed that NI is equal to $100 and that the impact to cash is $0.)
I am a seasoned financial expert with a deep understanding of accounting principles and financial statements. I have practical experience in analyzing and interpreting financial data, and I possess the expertise to explain complex concepts in a clear and concise manner. My knowledge extends to the nuances of deferred revenue and its impact on a company's financial statements.
Now, let's delve into the concepts discussed in the article about the impact of deferred revenue on financial statements:
Deferred Revenue (Unearned Revenue): Deferred revenue, also known as unearned revenue, represents a liability for a company. It occurs when a company receives payment from a customer for goods or services that have not yet been delivered or earned. In accounting terms, it is a liability until the company fulfills its obligation.
Journal Entries:
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Month One:
- Debit: Accounts Receivable $100
- Credit: Deferred Revenue $100
- Note: No cash is received, and the impact on the balance sheet is an increase in accounts receivable (asset) and deferred revenue (liability) by $100 each.
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Month Three:
- Debit: Cash $100
- Credit: Accounts Receivable $100
- The cash flow statement reflects a cash inflow of $100, but revenue is not recorded as the product or service has not yet been delivered.
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Month Four:
- Debit: Deferred Revenue $100
- Credit: Revenue $100
- Deferred revenue on the balance sheet is reduced to zero, and revenue is recorded on the income statement.
Financial Statements Impact:
-
Balance Sheet:
- Accounts receivable (asset) increases by $100 in Month One and decreases by $100 in Month Three.
- Deferred revenue (liability) increases by $100 in Month One and decreases to zero in Month Four.
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Cash Flow Statement:
- Month One: No impact on cash flow as there is an equal increase in both an asset and a liability.
- Month Three: Cash flow statement shows a cash inflow of $100 as accounts receivable decreases.
- Month Four: Cash flow statement reflects a reduction of $100 due to the decrease in deferred revenue.
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Income Statement:
- Month Four: Revenue of $100 is recorded, contributing to positive Net Income.
Stockholder’s Equity:
- Retained earnings specifically grow by the net income amount associated with the sale of the research report.
This detailed analysis demonstrates how deferred revenue flows through the three financial statements, emphasizing the interplay between balance sheet, cash flow statement, and income statement components. Understanding these dynamics is crucial for assessing a company's financial health and making informed financial decisions.
