Accounting: The Language of Business - Vol. 2 (Intermediate: Part 30)

There is no accounting for tastes, as the woman said when someone told her her son was wanted by the police.

Franklin P. Adams

Review of the Accounting Cycle (part G)

by

Charles Lamson

Deferred Revenues. A deferred revenue occurs when a company receives cash before revenue should be recognized in the financial statements under accrual basis accounting. That is, deferred revenue represents cash that has been received before the occurrence of the underlying economic event that generates revenue. For example, a company receiving cash in advance for an online magazine subscription records deferred revenue. The cash receipt occurs on the first day of the year, but the revenue is recognized only when the magazine is made available for use (i.e., delivered) over the subscription period. Thus, the company should not record the full amount of the revenue until the product has been provided over the entire term of the subscription. Deferred revenues are also referred to as unearned revenues or advanced collections.

Companies record unearned revenues as liabilities until control of a good or service passes to the consumer. Therefore, an adjusting journal entry for unearned revenues will cause a change in both a liability and a revenue account as the liability is derecognized and the revenue is recognized. Examples of unearned revenues include advanced collections of insurance, rent, and subscriptions. Exhibit 4.11 illustrates this liability-revenue relationship.

EXHIBIT 4.11 Deferred Revenues

If the company does not adjust unearned revenue, it overstates liabilities and understates revenues. The adjusting journal entry results in a debit to a liability account and a credit to a revenue account. It may be the case that the company initially records the cash receipt as revenue, a scenario we will discuss in a future post. Example 4.7 presents preparing an adjusting journal entry for a deferred revenue situation.

EXAMPLE 4.7 Deferred Revenues

PROBLEM: Plush Service Corporation collected $25,000 on June 30, 2018, for services to be provided over the next 12 months.

Plush estimated that 30% of the service fees collected in advance had been performed by the end of the year. As Illustrated in Example 4.2 from part 26 on the date it received the cash, Plush made the following journal entry to increase cash, an asset, and increase unearned service revenue, a liability:

What adjusting journal entry is needed on December 31? Prepare the t-accounts (for more about t-accounts, see part 27) for unearned service revenue and service revenue both before and after the adjusting journal entry.

SOLUTION: The t-accounts for the unearned service revenue and service revenue accounts would appear as follows on December 31 before Plush records the adjusting journal entry and posts it to the t-accounts.

On December 31, service revenue is understated because a portion of the unearned revenue has now been performed. Plush determines that $7,500 should be recorded as service revenue (30% * $25,000). In order to adjust the unearned service revenue liability account, Plush must prepare the following adjusting journal entry:

After posting the adjusting journal entries, Plush's accounts will reflect the correct balances of the liability and the revenue: 

*GORDON, RAEDY, SANNELLA, 2019, INTERMEDIATE ACCOUNTING, 2ND ED., PP. 108-110*

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