In this video we're going to work through an example of
Deferred Revenue in accounting.
[Music]
Hey there welcome back to Accounting Stuff.
I'm James and in a moment's time I'm going to take you through all
of the adjusting entries for a deferred revenue example…
Two examples… And just as a heads up
this video is part of a mini-series I've created covering
adjusting entries in accounting. Which you can find linked up here
and down below in the description. Last week we did prepaid expenses
and very soon I'll be making more videos covering accrued expenses
and accrued revenue. So hit the subscribe button
and click on the bell so you don't miss out on any of those.
But today we're going to focus on deferred revenue.
Let's get started… As usual I'd like to kick things off
with a definition. Deferred revenue is what we
call the payments that a business receives in advance
for goods or services that haven't yet been delivered or provided.
You might have heard of prepaid revenue or even unearned revenue
well all of these are actually the same thing. They're just different ways of
saying deferred revenue.
Umm.. okay
That's a bit odd… Three different terms that
all mean the same thing? Let's try to clear things up with
a couple of examples. In this first one I want you to imagine
that you're the owner of a seaplane. Random, I know.
But bear with me. I live in Vancouver and for a while now
I've been wanting to visit Vancouver Island. If I were to take the ferry out
there this whole trip would take me three to four hours
but lucky for me you own a seaplane. So I head downtown to the
seaplane terminal and boom! There's a spot on your seaplane
and it's leaving in 20 minutes. The ticket cost me $200
so I pay you the money and half an hour later we're
checking out the beautiful gardens on the island.
In this transaction you are the seller and I'm the buyer.
You provided me with a service by flying me out from Vancouver
all the way over to the island. The question is…
How should you account for this transaction? Well as the owner of the seaplane
you've received $200 in cash. Cash is a type of asset
the “A” in DEALER so debits increase it
and credits decrease it. Your cash balance has gone up
so you need to debit your cash account by $200 to increase your cash.
The other side of this transaction is going to affect revenue
in your income statement. Revenue is the R in DEALER
a normal credit account. So credits increase it
and debits decrease it. Your revenue has gone up
so you credit your revenue account by $200 to increase your income.
This is what your journal entry looks like and we can see how this journal entry
affects your general ledger using T accounts.
*coughs* Sorry I've got a sore throat today.
This journal entry affects two accounts cash and revenue.
Remember when using T accounts debits always go on the left
and credits always go on the right. So we debit your cash t-account
by $200 to increase cash in your balance sheet
and credit the revenue t account by $200 to increase revenue in your income statement.
Nice one that's the first example finished. It wasn't so bad was it?
You're probably thinking… Well yes…
Because there weren't any adjusting entries in this one.
You are spot on. This transaction didn't include
any deferred revenue or adjusting entries of any kind
because both the payment and services happened on the same day
in the same accounting period. For deferred revenue to get involved
in all of this we would need a special set of circumstances.
I would need to pay to you in advance in a past accounting period
and you will need to be providing me with the service in the future accounting period.
I'll show you how this works
in this second example. This time no more seaplanes.
I want you to picture yourself as a commercial pilot on a passenger jet.
It's June and I'm getting homesick I want to buy a return flight from
Vancouver to the UK to see all of my friends family.
It's been ages since my last visit so this time I decide to go there
for a whole month. I buy a return flight for $800 in June
on your airline. My outbound flight is going
to be the next month in July and the return leg is going to happen
the following month in August. This is our timeline
we have three accounting periods June, July and August.
To account for this transaction you're going to need post three
adjusting entries. One in each month
so let's do the first one. In June I paid for my tickets
but from your point of view at the airline you received $800 in cash.
You need to post a journal to debit your cash account by $800
to increase your cash. Right up to this point
this journal is looking very familiar. It's basically the same as the one
from the first example. You just need to post another $800 credit
to revenue and we’re go… *buzz*
*buzz*
Err..
this is embarrassing
let me think… You're a commercial pilot of an
international airline. Large businesses like that
use the accrual basis of accounting but if we were to recognise this income
right now then we would be cash accounting because
in cash accounting you record revenue as you receive the cash.
Whoops so we weren’t meant to credit revenue this time round
because we are accrual accounting. Okay I think I've got this now…
This time we don't credit revenue in the income statement because
we are accrual accounting. In accrual accounting revenue
is recognised as it's earned not when cash changes hands.
You haven't provided me with the service yet so you can't
recognise any of this revenue. So this entry can't go anywhere
that affects the income statement. So that leaves us with one option
the balance sheet. But is deferred revenue
an asset or a liability? Let's work it out.
Assets bring us future economic benefit
whereas liabilities involve a future economic sacrifice.
In this situation I've already paid for a plane ticket
so now it's down to you to fly me out to the UK and back.
You've got work to do. So you are going to make a
future economic sacrifice. So you need to recognise this
deferred revenue as a liability in the balance sheet.
In fact deferred revenue is always recognised as a liability
in the balance sheet. So the other side of this
journal entry is going to need to increase our deferred revenue
in the balance sheet. Deferred revenue is a liability
the L in DEALER so it's normal credit account.
Credits increase it and debits decrease it. So you need to credit your deferred revenue
in the balance sheet to increase it by $800. Let's see how this journal affects
your general ledger. Now you've got three t accounts.
Cash and deferred revenue in the balance sheet and revenue
normal revenue in the income statement. Your cash account has a debit
balance of $800 from my initial payment and your unearned or
prepaid revenue account holds a liability of $800.
The normal revenue account is empty because we can't recognise any revenue
at this point. Let's fast forward to the end of July.
You've flown me out to London so half of my return trip is complete.
If revenue is recorded as it’s earned then you've earned half of your income.
The problem is as things currently stand you're holding $800
as a liability in the balance sheet. This deferred revenue is not the
same thing as normal revenue that flows through your income statement.
You're going to need post an adjusting entry to fix this situation.
Let's do it. We'll start off by debiting
deferred revenue by $400 because we want to reduce
this liability in the balance sheet and release half of it
to the income statement. But where does the other side
of this adjusting journal entry go? We need to credit to the revenue account
by $400 to increase our revenue in the income statement.
Let's jot down how this adjusting entry is going to affect
your t accounts. We need to debit the left-hand side
of the deferred revenue T account by $400 and credit the right-hand side of
the revenue t account by $400. So as things currently stand you
have cash of $800 from that initial payment and you are holding deferred revenue
of $400 as a liability in your balance sheet.
We've released the other $400 which we now recognise as
revenue in the income statement. In August you fly me back to Vancouver
so the second leg of our round trip is complete.
You have one more adjusting entry to post. This adjusting entry is going to be
exactly the same as the one that we posted previously.
We need to debit deferred revenue by $400 to decrease it
in the balance sheet and credit the normal revenue account by
$400 to increase that in the income statement.
You post this adjusting journal entry and it hits your general ledger.
So in your August balance sheet you are still carrying that $800 of cash
from the initial transaction but you no longer have any deferred revenue.
Why? Because it has all been released
to the income statement. $400 in July when you performed
half of the services and the other $400 in August where
you completed the roundtrip. You have successfully recorded
your revenues as they were earned. So your books are in line with
the accrual basis of accounting.
Nice one!
This was part three in the adjusting entries miniseries.
I'm going to be releasing more videos covering accrued expenses and
accrued revenue very soon so click on this circle to subscribe
so you don't miss out on any of those. I've already made videos covering
the big picture of adjusting entries and prepaid expenses.
Which you can find in the playlist over here.
As always if you've got any questions let me know down below
in the comments or message me directly on instagram
@accountingstuff