Accounting for Deferred Revenues
Deferred revenues are accounted for under the realization concept. Before learning what deferred revenues are and how we can account these for let’s read about the realization concept first;
Realization Concept
The realization concept is an accounting concept that states that when a company sells or delivers its goods or services, the transaction can be recorded as an income — even if it hasn’t been paid for by the customer.
The realization concept required that revenue shall be recorded when goods are delivered or services are rendered, and the customer is liable to pay hence, revenues are recognized in the same period as the delivery or rendering of the service, regardless of a time lag between delivery and payment.
The realization concept requires that you record revenue when you’ve fulfilled your obligations to a customer, which is different from recording revenue when you get paid for your goods or services in a cash-based accounting system.
What does this mean? Let’s say that you’re a plumber who has agreed to fix someone’s sink the following week. If money hasn’t changed hands yet, there’s no need to record the revenue in your books—you haven’t earned it until the job is done. Once the sink is fixed, however, and the customer has agreed to pay you $300, then it’s time to record $300 in your income statement even if the customer has not paid yet.
rent for the month of July, 20X2.
Application of Realization concept
Realization is a concept in accounting that refers to the moment at which a company recognizes a good or service is being sold. The good or service must be completed, delivered
When it comes to the time of billing, the concept of realization is usually very important in an accounting sense. It’s what makes sure that you are correctly recording your revenues and expenses in accordance with the realization principle, which states that revenues and expenses should be recorded when they are earned or incurred rather than when cash is received or paid out.
With respect to the revenue realization, there could possibly arise the following two scenarios;
a. Accrued Income
The business has provided the services or rendered its goods for which payment by the customers will be paid later. Consider our example of the Electricity Company in the previous section. Although the customers of the company had consumed the electricity for the month of June, 20X2, the power company will issue the bills on the 1st of September, 20X2, and will receive the payment accordingly.
However, based on the accrual basis of accounting the Power Supply Company is required to record the revenue for the month of June 20X2. Such revenue which is recorded without sending the actual billing to its customer is called accrued Income.
b. Unearned / Deferred Revenue
Airlines earn revenue by providing flight services to their customers. It is a common practice that they receive payment in advance from their customers when they book tickets, and however, they shall record this as revenue later when they provide their services (flight services) to their customers.
The Airlines could book revenue as unearned/ deferred revenues as soon as they book the ticket in advance and then recognize that revenue in another month when the flight takes place.
