Mastering specific terminologies is indispensable in any field, and this holds particularly true for accounting and financial management.
Among these terms, ‘deferred revenue’ and ‘accrued revenue’ are critical concepts representing different facets of revenue recognition per the Generally Accepted Accounting Principles (GAAP).
In this article, we will demystify these concepts, walking through their definitions, and examples, and importantly, highlighting the primary differences between the two.
This comprehensive exploration aims to provide a deeper understanding of deferred and accrued revenues, thus paving the way for more effective financial decision-making.
What Is Deferred Revenue?
Deferred revenue, also known as unearned revenue, is a liability that a company records on its balance sheet when it receives payment for goods or services that it has yet to deliver or perform.
In essence, the company owes a service to its customer. The recognition of the revenue is deferred until the company fulfills its obligation to the customer.
An Example of Deferred Revenue
Let’s consider a software company that offers annual subscriptions. A customer pays $1,200 in January for a subscription that covers the entire year.
Despite receiving the payment, the company cannot recognize the full $1,200 as revenue in January because it has yet to provide the services for the upcoming months.
Instead, it records the $1,200 as deferred revenue, and as each month passes, it gradually recognizes $100 ($1,200/12 months) as revenue, simultaneously decreasing the deferred revenue balance by the same amount.
What Is Accrued Revenue?
Accrued revenue, on the other hand, is revenue that a company has earned by providing goods or services, but has not yet received payment for.
This accounting concept is primarily concerned with the revenue recognition principle that states that revenue should be recognized when earned, regardless of when the payment is received.
An Example of Accrued Revenue
Imagine a consulting firm that provides services to a client in December, but the invoice of $5,000 won’t be paid until January of the following year.
The firm has already performed the service (hence, earned the revenue) in December, but it hasn’t received the payment. So, it records $5,000 as accrued revenue, an asset, on the balance sheet in December. Once payment is received in January, the accrued revenue entry is reversed, and cash is debited.
Deferred Revenue vs Accrued Revenue: Key Differences
While both deferred and accrued revenues deal with the timing of revenue recognition, they stand at opposite ends of the transaction timeline.
Deferred revenue involves receiving payment first and providing the goods or services later. It is classified as a liability because the company has an obligation to the customer. Accrued revenue, conversely, involves providing goods or services first and receiving payment later. It is an asset as the company has a claim to a future cash receipt.
Moreover, the recognition of deferred revenue decreases liability and increases revenue over time as the company fulfills its obligations. On the other hand, the recognition of accrued revenue decreases an asset (once payment is received) and has already increased revenue when the revenue was earned.
Understanding the concepts of deferred and accrued revenues is essential in business accounting as it aids in the accurate portrayal of a company’s financial health and operational efficiency.
While these concepts may seem complex, their practical understanding can help businesses in better planning, forecasting, and making informed financial decisions.
It’s essential to comprehend these revenue recognition principles to ensure compliance with GAAP and to provide a realistic financial picture to stakeholders.
In the end, the proficient handling of these revenue types can lead to more accurate financial statements, thereby benefiting the overall strategic decision-making of the business.