When we begin to talk about "deferred" items in relation to accounting transactions, we begin to go further into the reporting side of accounting, and in order to keep this article as simple as possible, we are not going to expand on the relationship of deferred items to balance sheets, profit and loss sheets, etc. We're simply going to define what deferred revenue is, and how you would record such an item.
Deferred revenue refers to an item that will initially be recorded as a liability, but is expected to become an asset over time and/or through the normal operations of the business. Deferred revenue is sometimes called unearned revenue, and it is through the use of this term that I believe it makes it easier to understand why it is initially a liability but is later transferred to an asset item.
One of the most basic concepts of accounting involves determining if an item is an asset or a liability. Cash is an asset. Period. It is never a liability; never an expense; never anything but an asset. Cash is a current asset, and serves to increase the net worth of whoever is in possession of the cash. But when the cash is unearned, or you haven't performed the service or provided the product that the cash was used to purchase, it must be treated as a liability. You still owe the purchaser something.
If you have a customer that prepays for something say, 6 months before you actually provide the service or product, how do you record such a payment? How do we account for this type of transaction? Enter the term "deferred revenue". Every accounting system uses journals that record deferred items; and there generally two major categories of deferrals: deferred expenses and deferred income or revenue. The most important aspect of learning to deal with deferred items, is learning to understand what deferred means, and how to recognize an item that should be deferred.
We've defined deferred expenses as an item that is prepaid and is initially recorded as an asset to a business and we've defined deferred revenue as unearned income that must be recorded as a liability to a business. If you're like most, you already have noticed the oddity in the fact that a deferred expense is an asset, and deferred revenue is a liability, but it also makes for a great way to remember how to classify income and expense when they fall under the category of "deferred". The deferred status automatically changes their normal status from asset to liability, and vice versa. Now let's look at some examples of deferred revenue and how to determine if something is deferred revenue and a future liability.
Unearned rent is deferred revenue. When you are a landlord, and you have a tenant, or renter you are responsible to that individual in providing them with the space they rent. If a renter pays you yearly for rented space, you are obligated to provide that space for a period of one year. What would happen if you failed to provide that space for the term agreed? Would you owe the renter a refund? Most definitely; and it is in this spirit that the unearned revenue is determined to be a liability. You have received the money, but have not provided the service or product, as of yet. At the end of the year, you will have fulfilled your responsibility, and the rent will be fully realized as earned income.
Information is for educational and informational purposes only and is not be interpreted as financial or legal advice. This does not represent a recommendation to buy, sell, or hold any security. Please consult your financial advisor.