Study: Deferred Revenues: Cash is Received BEFORE Revenue is Recognized
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Slides 1-3 (1m:02s)
Links to an external site.Welcome to Introduction to Accounting Preparing for a User’s Perspective
Deferred Revenues: Cash is Received BEFORE Revenue is Recognized
Slide 2
In the accrual accounting video, when I introduced the revenue recognition principle and the matching principle, I went through the following key points about when revenue should be recognized.
Revenue should be recognized in the accounting period when they become realized or realizable and are earned.
That means you have to deliver a good or service. You should receive cash or claims to cash, such as receivable, or assets that can be readily converted to cash, and you should substantially complete or deliver the promised goods or services.
When these criteria are met, then you would recognize the revenue.
Slide 3
Also in that video I introduced the three common revenue recognition situations. In this video we will talk about deferred revenue. When cash is received before the revenue is recognized. In this case, cash is received in the first year, but the revenue needs to be deferred until it is actually earned in the second year.
Slides 4-6 (4m:50s)
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The best way to learn how to deal with deferred revenue is to simply do an example.
Example: On November 1, X1 Landlord Co. received $18,000 cash from Renter Co. to pay for the following 18 month rental period ending on April 30, X3. Record all required entries AND adjusting entries for 20X1-20X3 as per the revenue recognition principle.
Per the revenue recognition principle when should the rent revenue be recognized? I have found in situations like this the best thing to do is draw a diagram that helps me to visually see when this landlord is earning the revenue. I first start with the key dates. November 1st was when the landlord received an $18,000 payment that would cover a period extending to April 30th, X3, 18 months later.
In this case it is $18,000 paid for 18 months’ worth of rent. The monthly rental rate would then have to be $18,000 divided by 18 months or $1,000 per month. If you think about the math then, the first two months would be $2,000 earned in X1. The next year has 12 months for $12,000 and 20X3 has 4 months for $4,000. That’s what should make it into our books, so if we finish the 20X1 income statement and it doesn’t show $2,000 of rental income from this situation, we did something wrong. In X2, if it doesn’t show $12,000 of rental income, we did something wrong. In X3, if it doesn’t show $4,000 of rental income, then we did something wrong. That’s when it should be recognized, because that is when the landlord earned the revenue.
Slide 5
Now that we have the vision of the recognition in our mind, let’s do the journal entries.
On November 1st, cash was received. So this was a debit to cash increasing the cash account. Now the question is, what should the credit be to balance out this debit to cash? If we earned all the rental revenue in X1, it would be a credit to rental revenue, but we didn’t earn it yet so we have to say we owe the tenant $18,000 worth of rental services. This is called unearned rent revenues, meaning we owe the tenant $18,000. Now as time passes, this liability will decrease and the landlord’s revenue will increase.
Down below I have shown the unearned rent revenue ledger account in T-account format. As we post journal entries to the ledger account we will update the balance, I won’t bother updating the cash and the revenues account, just the unearned revenues account, just the unearned rent revenues account so we can track what’s happening in this given situation.
By posting our credit to unearned rent revenues to the unearned rent revenue [ledger] account, the unearned rent revenue account increased by $18,000.
We then have to jump to the end of the year and say “OK, have we earned any of this unearned rent revenue?” The answer is, we have. We’ve earned two months’ worth so we would have to reduce that liability by $2,000 and record rent revenue of $2,000.
How much in rental services do we still owe the tenant? Let’s post the debit to unearned rent revenues of $2,000, thus arriving at $16,000 of rental services that we still owe our tenant.
Let’s jump on the next one. In 20X2, we didn’t receive any more payments from the tenant, but we did earn another $12,000 worth of rent. So let’s record that. We have $12,000 of rent revenue that we’ve earned, but the tenant didn’t pay us in this year so we can’t debit cash but they did pay us in the past. So we will reduce our liability to them. We’ve now earned $12,000 of this $16,000 payment. We have now earned $12,000 more of this amount that we’ve received payment for.
If we post that to the ledger account by debiting unearned rent revenue by $12,000 our new balance amount owed to the tenant is $4,000.
Jump to the next year. We have to record another adjusting entry to show that we have now earned another $4,000 and thus reduced the remaining liability.
Let’s post that to the ledger account and we show that at the end of this year, we owe nothing more to this tenant and this deferred revenue has now been fully realized and recognized on the income statement.
Slide 6
We showed that we were supposed to have $2,000 of rental revenue in 20X1 and that is what got recorded. $12,000 in X2, and that’s what got recorded. $4,000 in X3, and that’s what got recorded.
It appears that our journal entries properly updated the rent revenue account to show what we actually recognized.
Do our recognized revenues comply with the revenue recognition principle? Yes they do.
Slides 7-9 (2m:17s)
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Example: On December 14, X1, Roofer Co. received $5,000 cash from House Co. to install a new roof in February X2 of the following year. On February 8th, X2 the roofer incurred $3,000 to install the roof. Record all required entries AND adjusting entries for 20X1-20X2 as per the revenue recognition principle.
Per the revenue recognition principle WHEN should the roofer recognize the revenue?
The answer is when those revenues are realized or realizable and he’s earned it. Well, how does a roofer earn revenue? He puts on roofs.
So in 12/14 he received payment. Cash was received but no revenues were recognized because hasn’t done any work yet.
Whereas on February 8th, he did the work and that’s when the $5,000 in revenues will be recognized.
Slide 8
Let’s do the journal entries. On December 14th, he received cash. What should the credit be? It can’t be revenues because he hasn’t earned it yet. In other words, he owes that service and therefore it is an unearned revenue.
Posting the unearned revenue to the unearned revenue account that’s a credit of $5,000. As of the end of X1, no adjustments are needed because he hasn’t done any work to earn that revenue. So the ending balance is still $5,000. In the following year, when he actually does the work, he’s going to recognize revenue of $5,000 AND reduce this liability [unearned rent revenue] by debiting it.
He also needs to recognize the related expense which is $3,000, so he may have taken the asphalt shingles out of his inventory, credit that and debit cost of goods sold $3,000. I’m assuming he did all the work himself so we won’t worry about the employee wages expense.
By posting this debit to unearned revenues, we now can update the unearned revenue account to show that the balance is zero.
Slide 9
To summarize what we just did, on 12/14 the roofer received payment, but we knew that no revenues should be recognized. Then on February 8th, he delivered the service and we knew that $5,000 of revenues should be recognized. Is that what made it on the income statement? Yes, we had $5,000 of sales revenue in X2 and we had no revenues in X1 and we’ve handled that properly.
Slides 10-11 (1m:12s)
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Revenue recognition key points.
1) Only recognize revenue in the accounting period in which it becomes realized (or realizable) and earned.
2) If you receive a prepayment it really should be a liability until it becomes realized (or realizable) and earned. The name of that liability is often referred to as Unearned Revenue.
3) At year-end review all unearned revenue account balances, which will appear on the balance sheet, to determine if you have now earned some of them and adjust them accordingly. In other words, you just look at this and say “Hey haven’t we earned some of that?” If so, [you should] reduce the liability, and record the revenue on the income statement.
4) At year-end review your revenue account balances to ensure you really did earn all them and adjust accordingly. In other words, look at these revenues, if there are some revenues in there that you know you haven’t earned yet, you might have to reverse them out by debiting revenues and setting them up as an unearned revenue [by crediting an unearned revenue account].
Slide 11
I hope this has helped you understand one of the accrual accounting issues with revenue recognition, which is called deferred revenues.
I wish you all the best on the quiz.
Aloha.