Deferred income, also known as deferred revenue, unearned revenue, or customer deposits, is money received by a business for goods or services that it has not yet delivered or performed. In essence, the business has an obligation to the customer in the form of goods or services to be provided in the future.
When a business receives payment in advance, it records the amount as deferred income on its balance sheet, under liabilities. As the business delivers the goods or performs the services, it gradually reduces the deferred income and recognizes it as revenue on its income statement.
This process ensures that revenue is recognized in the correct accounting period according to the revenue recognition principle, a core tenet of accrual accounting. The principle states that revenue should be recognized in the period the goods are delivered or the service is performed, regardless of when payment is received.
Common examples of situations that lead to deferred income include magazine subscriptions, prepaid insurance policies, and annual software license renewals. In all these cases, the customer pays up front for a good or service that will be delivered or performed over time.
Example of Deferred Income
Let’s consider a software company that sells annual licenses for its product. A customer pays $1,200 upfront for a license that covers an entire year.
When the payment is received, the software company has an obligation to provide access to its software for 12 months. This obligation is a liability, so the company records the $1,200 as deferred income (or deferred revenue) on its balance sheet.
The journal entry at the time of receiving the payment would be:
- Debit Cash $1,200
- Credit Deferred Income $1,200
The software company hasn’t earned this revenue yet because it hasn’t provided all the services the customer has paid for.
As the company fulfills its obligation by providing the software service over time, it recognizes the deferred income as revenue. If the company uses monthly accounting periods, it would recognize $100 of revenue each month ($1,200 / 12 months).
Each month, the journal entry would be:
- Debit Deferred Income $100
- Credit Revenue $100
This moves $100 from deferred income (a liability account) to revenue (part of the income statement). After 12 months, the company will have recognized all $1,200 as revenue, and the balance in the Deferred Income account related to this transaction would be $0.