A deferred credit, also known as a deferred revenue or unearned revenue, is money received by a company for goods or services that it has not yet delivered or performed. In other words, the company has a liability to provide a good or service in the future.
When a company receives payment in advance, it records the amount as a deferred credit on its balance sheet, in a liability account. As the company delivers the goods or performs the services, it gradually reduces the deferred credit and recognizes the amount as revenue on its income statement.
This process ensures that revenue is recognized in the correct period according to the revenue recognition principle, which is a key concept in accrual accounting. The revenue recognition principle states that revenue should be recognized in the period in which the goods are delivered or the service is performed, regardless of when payment is received.
A common example of a deferred credit is a magazine subscription. If a customer pays in advance for a one-year subscription, the magazine company would initially record the payment as a deferred credit. Then, as each issue is delivered, the company would recognize a portion of the subscription fee as revenue.
Example of Deferred Credit
Let’s consider an example involving a magazine subscription, which is a common type of deferred credit or deferred revenue.
Suppose a customer pays $120 in January for a one-year subscription to a monthly magazine. The magazine company would record this transaction as follows:
On Receipt of Payment: When the magazine company receives the $120 payment, it would record the amount as a deferred credit (deferred revenue or unearned revenue), because it has an obligation to deliver magazines to the customer over the next 12 months.
The journal entry would look like this:
- Debit Cash $120
- Credit Deferred Revenue $120
This entry increases the company’s cash account (an asset) and also increases its deferred revenue account (a liability), reflecting its obligation to deliver magazines in the future.
Each Month Throughout the Year: Each month, as the company delivers a magazine to the customer, it would recognize a portion of the subscription fee as revenue. Since the subscription covers 12 issues, the company would recognize $10 of revenue each month ($120 / 12 months).
The monthly journal entry would look like this:
- Debit Deferred Revenue $10
- Credit Magazine Subscription Revenue $10
This entry reduces the deferred revenue account (decreasing the liability) and increases the Magazine Subscription Revenue account (recognizing revenue on the income statement).
By the end of the year, the entire $120 would have been recognized as Magazine Subscription Revenue on the company’s income statement, and the balance in the Deferred Revenue account would be $0, reflecting the fact that the company has fulfilled its obligation to deliver magazines to the customer.