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.
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, also called prepaid expenses or accrued 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.
Once the services are performed, the income can be recognized with the following entry: This entry is decreasing the liability account and increasing revenue.
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.
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.
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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