Need for Deferred Revenue
Financial Reporting Standards are based upon the concept of matching which means that income and expenses should be recorded in the financial period to which they pertain. Although this sounds relatively simple, accounting for long term transactions that cover a significant amount of time may result in complications. Similarly the concept of accruals states that the risk and rewards of any financial transaction should be considered when determining the recording period irrespective of time of transfer of consideration. In short, if a company has received or transferred the risk and rewards of any goods or services to a customer, the transaction has taken place in light of financial reporting standards and should be recorded.
This issue can have significant consequences when it comes to recording large transactions close to year end. Financial reporting standards especially highlight the matter of recognition of revenue since manipulation is very straight forward. For example, a company that enters into long term construction contracts may deliberately record all payments received in advance as revenue irrespective of the fact that they relate to services to be provided in the future to inflate profits. Similarly, a school receiving tuition fees in advance may incorrectly record them as revenue if the financial year closes half way through the school year.
Nature of Deferred Revenue
To address this issue, financial reporting standards prescribe the implementation of the concept of deferred revenue. Simply put, deferred revenue represents cash received against which goods or services have to be delivered or provided. Applying, the concept of matching and accruals, any amounts received from customers against which services or goods have not been provided should not be recorded in the period in which payment has been received. The revenue should only be recorded once the goods are delivered or the services are provided irrespective of when payment was received.
Accounting for Deferred Revenue
Deferred revenue, therefore, is recorded as a liability when payment is received and is represented as a credit balance at the end of the financial year. It may be classified in long term or short term liabilities depending on the timing of realization of such revenue. Once the goods or services that the advance payment relates to have been delivered or provided, the company is entitled to reduce its liability and record revenue to the extent of the transaction completed.