Demystifying Deferred Revenue in U.S. GAAP for the FAR CPA Exam
Introduction
Deferred revenue, also known as unearned revenue, is an accounting concept that is often
encountered in businesses that receive payments in advance for goods or services. This can
range from magazine subscriptions to pre-selling software licenses. For candidates preparing for the Financial Accounting and Reporting (FAR) section of the CPA exam, getting the hang of deferred revenue accounting under U.S. Generally Accepted Accounting Principles (U.S. GAAP) is crucial.
Definitions
Deferred Revenue
Deferred revenue represents funds received in advance for goods or services that are yet to be delivered or performed. Essentially, the company owes a “performance obligation” to the
customer.
Recognition and Measurement
Deferred revenue should be recognized when a business receives payment in advance, and the amount is measurable, but the company has not yet fulfilled its obligation to provide goods or services.
When to Recognize Revenue
The revenue is recognized as the obligations are fulfilled. For example, if a customer pays for a one-year subscription, the deferred revenue is recognized as income each month as the service is provided.
Journal Entries
Accounting for deferred revenue involves two stages: the initial recognition of the receipt and
the subsequent recognition of revenue.
Example 1: Initial Recognition of Deferred Revenue
A software company receives $1,200 in January for a one-year subscription. The journal entry to record the transaction would be:
Debit Cash $1,200
Credit Deferred Revenue $1,200
Example 2: Monthly Revenue Recognition
Each month, the company would recognize $100 of the deferred revenue as earned revenue. The journal entry would be:
Debit Deferred Revenue $100
Credit Revenue $100
This would continue each month until the one-year subscription is fully provided, and the
deferred revenue account balance is zero.
Example 3: Multiple Performance Obligations
Suppose a gym charges a one-time initiation fee of $200 and a monthly membership fee of $50. If a customer pays $600 upfront for the initiation and the first eight months, the initial journal entry would be:
Debit Cash $600
Credit Deferred Revenue $600
Here, we can allocate $200 to the initiation fee and $400 to the monthly fees. The initiation can be recognized immediately if there is no ongoing obligation related to it:
Debit Deferred Revenue $200
Credit Revenue $200
For the monthly fees, $50 would be recognized each month:
Debit Deferred Revenue $50
Credit Revenue $50
Disclosures
Deferred revenue is generally presented as a current liability on the balance sheet, unless the obligations extend beyond a year. Companies must disclose their revenue recognition policies and any significant deferred revenue balances in the footnotes of the financial statements.