Deferred Revenue Principles

Deferred Revenue

A liability recognized when cash is received before the service is provided or before the goods are shipped to customers.

How is the change in the deferred revenue account calculated for a period?

Cash received during the period less revenue earned for the period.

On March 31, 2005, Dallas Co. received an advance payment of 60% of the sales price for special order goods to be manufactured and delivered within five months. At the same time, Dallas subcontracted for production of the special order goods at a price equal to 40% of the main contract price. What liabilities should be reported in Dallas' March 31, 2005 balance sheet?

The only liability (deferred revenue) to be recorded is the advance for 60% of the main contract price. Dallas received this cash and has a liability for that amount until it performs on the contract. Dallas has no liability for the subcontracted production because no resources have been exchanged.

Deferred Revenue Example 2

A tenant pays a building management firm $24,000 for two years' rent on August 1, 20x3 ($1,000 per month). The rental period begins on that date and the building management firm has a calendar fiscal year. Provide the journal entries for 20x3. Solution: Aug 1, 20x3 Cash 24,000 Unearned Rent 24,000 Dec 31, 20x3 (adjusting journal entry) Unearned rent 5,000 Rent revenue 5,000 $5,000 = $1,000 per month x 5 months August - December. The 20x3 income statement will reflect $5,000 of rent revenue. The ending balance in unearned rent for 12/31/x3 is $19,000 ($24,000 - $5,000) of which $12,000 is a current liability (the portion relating to 20x4), and $7,000 is a noncurrent liability (the portion relating to 20x5).

Deferred Revenue

A. Deferred revenues are liabilities representing cash received for goods not yet delivered or services to be performed. Recognition of revenue occurs when the firm provides the good or service at which point the deferred revenue (liability) is reduced. These liabilities often are reduced in adjusting entries. For example, a company may prepare an adjusting entry to recognize rent revenue and reduce unearned rent revenue.

Deferred revenues

B. Cash representing revenue that will be earned in the future is credited to one of the following accounts, which are simply different names for the same account: 1. Deferred revenue; 2. Unearned revenue; 3. Revenue received in advance. C. Each of the above accounts is a liability. CPA exam questions in this area ask the candidate to determine the ending balances of two accounts: 1. Revenue to be recognized in income for the period; and 2. The amount of unearned revenue to be reported in the balance sheet.

Deferred Revenue

D. Under the revenue recognition principle, revenue is not recognized unless it is (1) earned, and (2) realizable. In the case of deferred revenue, the cash collection occurs before the earnings process is complete. Such revenue is common for firms that require partial or full payment before providing service. Examples include real estate management companies (unearned rent), publishing companies (magazine subscriptions) and airline companies (flight liability).

Deferred Revenue Example

Duration Magazine Inc. collects subscriptions in advance from customers and records deferred revenue. As magazines are distributed over the subscription period, revenue is recognized. The beginning balance of deferred subscription revenue is $24,000. During the year, $87,000 of cash is collected. At the end of the year, the firm calculates from subscription data that the subscription value of magazines yet to be distributed is $37,000. The adjusting entry to record revenue for the period is: Deferred Subscription Revenue 74,000 Subscription Revenue 74,000* * $24,000 + $87,000 - $37,000 = $74,000

Deferred Revenue

E. A liability is recognized upon receipt of cash. As the service or good is provided, the liability is extinguished because the revenue is earned. In many cases, the contract need not be fully executed before some revenue is recognized. In these cases, the revenue is recognized based on the percentage of the total contract that has been provided.

Deferred Revenue Example (Account balances given)

Example: Account balances given The beginning and ending balances of unearned revenue for an airline company appear below. These amounts represent cash collected from customers for flights to be provided in the future. Beg. Unearned Revenue = $300,000 and ending = $410,000 During the year, the firm collected $760,000 from customers for flights. How much revenue was recognized during the year? Solution: Any operating account such as unearned revenue can be analyzed using a T account or an equation. The equation approach is illustrated below: Beginning balance of unearned revenue + increase - decrease = Ending balance of unearned revenue The increase for this account is the amount of cash received during the period; the decrease is the amount of revenue recognized. Beginning balance ($300,000) + cash received ($760,000) - revenue earned = ending balance ($410,000) Solving for revenue earned yields $650,000. This amount is reported in the income statement. Summary entries can be reconstructed: Dr:Cash 760,000 Cr:Unearned Revenue 760,000 Dr:Unearned Revenue 650,000 Cr:Revenue 650,000

Total Revenue to be Recognized Example

Example: The following amounts were taken from the comparative financial statements of a large local firm: 12/31/x4 12/31/x3 Accounts receivable $20,000 $12,000 Unearned revenue 34,000 28,000 The accounts receivable represents billings after service was provided to customers. Unearned revenue represents cash collected before service was provided. Total cash received from customers during 20x4: $126,000 What amount of service revenue was recognized during the period? Solution: Accounts receivable is recognized when revenue is earned. The customer is billed after the service is provided. Unearned revenue is recognized when customers pay in advance, before service is provided. Cash received increases the unearned revenue account while reducing accounts receivable. Recognizing earned revenue has the opposite effect: it reduces unearned revenue while increasing the accounts receivable account. Again, a T account or equation analysis helps. Although the amount of cash received on accounts receivable and the amount of cash received in advance from customers cannot be determined from the information provided, the total cash received from both sources is provided. The solution strategy is to set up the analysis of the two balance sheet accounts and place the revenue amounts on the same side of the respective equations: Accounts receivable: Beg. Bal + revenue earned - cash received = End. Bal revenue earned = End. Bal + cash received - Beg. Bal Unearned revenue: Beg. Bal + cash received - revenue earned = End. Bal revenue earned = Beg. Bal + cash received - end. Bal -- CONTINUED ON NEXT CARD --

Example:Reporting cash as revenue on receipt

In some cases, firms record all cash received as revenue and then make an adjusting entry (1) to recognize the amount of unrecognized revenue to report in the balance sheet, and (2) to adjust revenue. At the beginning of the year, the balance in rent collected in advance (liability) was $56,000. During the year, the firm collected $520,000 in rent from tenants representing rentals of $2,000 per month. At year-end, 10 tenants had an average of eight months rent (at $2,000 per month) remaining on their contracts. The summary journal entries assuming that cash collected is recognized immediately as rent revenue are as follows: Dr:Cash 520,000 Cr:Rent Revenue 520,000 Dr:Rent Revenue 104,000 Cr:Rent collected in advance 104,000 The ending liability balance (rent collected in advance)= 10 tenants x 8 months remaining on average x $2,000 per month = $160,000 Analysis of rent collected in advance: Beginning balance ($56,000) + cash received ( $520,000) - rent revenue earned ( ? ) = ending balance ($160,000) Solving for rent revenue earned for the year yields $416,000. Because the firm has already recorded $520,000 in revenue upon cash collection, the adjustment is $104,000: $520,000 rent recognized previously less the actual revenue earned of $416,000. In this case, the liability balance is directly computed; the amount of revenue recognized is computed as one of the components of the change in the liability account.

How are deferred revenues expected to be earned more than one year from the balance sheet date classified?

Noncurrent liability.

Total Revenue to be Recognized Example (Part 2)

Repeat the last equation for each account, insert the known amounts, recall that total cash received amounted to $126,000, and add the equations together. AR: revenue earned = End. Bal + cash received - Beg. Bal = $20,000 $12,000 Unearned Rev: revenue earned = Beg. Bal + cash received - end. Bal = $28,000 $34,000 Sum: revenue earned = $48,000 + $126,000 - $46,000 = $128,000 Therefore, total revenue to be recognized for 20x4 equals $128,000. However, from the information provided, the revenue cannot be broken down by source (customers paying in advance vs. customers paying after service is provided). Short-cut approach: An alternative approach is to simply assume that one-half the total cash received relates to each of the two accounts (accounts receivable and unearned revenue). Again, an equation or T account may be used for the analysis; this time the account analysis can proceed separately for each account. Assume one-half of the cash (1/2 x $126,000 = $63,000) is applied to each account. Accounts receivable: Beg. Bal + revenue earned - cash received = End. Bal $12,000 + ? - $63,000 = $20,000 Unearned revenue: Beg. Bal + cash received - revenue earned = End. Bal $28,000 + $63,000 - ? = $34,000 Total revenue earned = $71,000 + $57,000 = $128,000. Note however that the individual amounts of revenue, $71,000 and $57,000, are most likely not the actual revenue amounts by sources. Only the total is correct.

Barnel Corp. owns and manages 19 apartment complexes. On signing a lease, each tenant must pay the first and last month's rent and a $500 refundable security deposit. The security deposits are rarely refunded in total, because cleaning costs of $150 per apartment are almost always deducted. About 30% of the time, the tenants are also charged for damages to the apartment, which typically cost $100 to repair. If a one-year lease is signed on a $900 per month apartment, what amount would Barnel report as refundable security deposit?

The damage deposit on all apartments is $500. Although it is likely that most tenants will be charged for some damages and cleaning, these reductions in the amount to be reimbursed cannot be anticipated. The damage to the apartments typically is not known until the end of the lease term. The firm must maintain its $500 liability until the condition of each apartment becomes known at the end of the lease term. The conditions causing the need for repair or cleaning may not have occurred as of the balance sheet date.

Buc Co. receives deposits from its customers to protect itself against nonpayments for future services. These deposits should be classified by Buc as

The firm has an obligation to return the deposit, and therefore records a liability upon receipt. It is probable that the deposit will be returned, and it is a result of a past transaction. A deposit meets the general definition of a liability.

A retail store sold gift certificates that are redeemable in merchandise. The gift certificates lapse one year after they are issued. How would the deferred revenue account be affected by each of the following? Redemption of certificates / Lapse of certificates

The redemption of the certificates would decrease deferred revenue and increase revenue because the earnings process is completed once the store delivers the merchandise. If the gift certificates lapse, this will also decrease unearned revenue and recognize other income or a payable if the governing authorizes require these amounts to be remitted as unclaimed property.

What accounts are used to record cash received from a customer before the revenue is earned?

Unearned revenue, revenue collected in advance.

Total Revenue to be Recognized

You may encounter situations in which firms require cash to be paid in advance for some services, while for other services the firm bills the customer after the service is provided. In this case, both unearned revenue and accounts receivable must be analyzed to uncover the total revenue to be recognized for the period.