Deferred revenue: an accounting term that deals with a specific type of timing difference
between getting paid by your customer and providing goods or services in return.
This short video starts with real-life examples of deferred revenue in companies in very different
industries, we subsequently discuss a common definition of deferred revenue, talk about
why this is such a great business model, and review the deferred revenue accounting entries.
Let's start with some examples.
What do Home Depot, the world's largest home improvement retailer, Salesforce, a leading
provider of enterprise software, and United Continental Holdings, a transporter of people
and cargo, have in common?
Each of these companies has a significant amount of deferred revenue.
Home Depot $1.7 billion, Salesforce $5.5 billion, and United $8.6 billion.
If you have any more examples of deferred revenue, please share them as a comment!
How does deferred revenue work for Home Depot?
Here are some excerpts from Home Depot's annual report.
"When we receive payment from customers before the customer has taken possession of the merchandise
or the service has been performed, the amount received is recorded as Deferred Revenue in
the accompanying Consolidated Balance Sheets until the sale or service is complete.
We also record Deferred Revenue for the sale of gift cards and recognize this revenue upon
the redemption of gift cards in Net Sales."
How does deferred revenue work for Salesforce?
"Deferred revenue primarily consists of billings or payments received in advance of revenue
recognition from subscription services.... and is recognized as
the revenue recognition criteria are met.
.... We generally invoice customers in annual installments."
How does deferred revenue work for United?
United actually has two types of deferred revenue, that are recognized in separate accounts
on the balance sheet.
The value of unused passenger tickets is included in current liabilities as Advance ticket sales
until the time the transportation is provided: $3.7 billion.
The second type of deferred revenue relates to frequent flyer miles.
"Mileage Plus program participants earn miles by flying on United and certain other participating airlines.
.... The Company records its obligation for future award redemptions using a deferred
revenue model.
.... The miles are recorded in Frequent flyer deferred revenue on the Company's consolidated
balance sheet and recognized into revenue when transportation is provided."
This liability is $4.9 billion.
So what is the common theme, and an accurate definition of deferred revenue?
Deferred revenue is a balance sheet account (on the liability side, what a company owes)
representing the obligation to deliver goods or perform services in the future for which
billing has already occurred and/or cash has been received.
If that accounting definition of deferred revenue still sounds a bit cryptic to you,
then think of the business model in construction: step one is to sign a contract for work to
be performed, then the construction contractor gets a down-payment from the customer, the
contractor uses this to buy materials and labor, delivers the finished project, and
recognizes the revenue.
Here's how the journal entries for deferred revenue work step by step.
We will record the journal entries for a two year service contract that runs from mid-2018
to mid-2020.
The customer pays the full amount of the contract upfront: debit cash on the assets side of
the balance sheet, credit deferred revenue on the liability side of the balance sheet.
For 2018, we book six months' worth of revenue: debit deferred revenue on the balance sheet,
credit revenue in the income statement.
At the end of 2018, 18 months of deferred revenue for the remainder of the contract
is still on the balance sheet.
For 2019, we book twelve months' worth of revenue: debit deferred revenue on the balance
sheet, credit revenue in the income statement.
For 2020, we book the remaining six months of revenue.
At the end of the contract, the sum of the debits and the credits in the deferred revenue
account should be equal.
Deferred revenue: a useful accounting concept, and a great business model!
Remember to put your examples in the comments box below this video.
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