In most cases, income from sales is recorded at the same time as the work is invoiced or payment is received. This is the way most contractors and suppliers record their sales and income. However, if you collect deposits or payments before work is completed or materials furnished, this revenue must be recorded as a liability, not income. This is called “deferred revenue” — and it must be handled differently because the income has not yet been earned.
Does this sound a bit confusing? No worries, we’ll take you through it step-by-step — and show you some examples.
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What does deferred revenue mean?
Deferred revenue, also called unearned revenue, is an accounting term that refers to money that is received for work that hasn’t been completed yet. In the construction industry, this would include customer deposits and any prepayments required when ordering materials.
Deferred revenue is essentially the opposite of accrued revenue, which is revenue that has been earned by the completion of the work. In accrual accounting, revenue is recognized when it’s earned, which is often stipulated by the contract.
Percent complete says that revenue is recognized as the work progresses, based on the percentage of costs that have been completed. Completed contract says that revenue is recognized only when the entire project has been completed.
Since revenue can only be recognized as income as the work is completed, deferred revenue cannot be considered income. It is initially entered as a liability because the work hasn’t been performed yet. We’ll talk about this more later.
Recording deferred revenue as a journal entry
As we mentioned above, since the work has not been completed, deferred revenue cannot be recorded as income. GAAP (Generally Accepted Accounting Principles) requires accounting conservatism, which means that companies must report the lowest possible profit. If a company reports deferred revenue as income earned, it is called aggressive accounting as it overstates sales revenue.
When a deposit or other deferred revenue is received from a customer, the deposit is recorded by debiting the bank account and crediting deferred revenue, which is a liability.
As the work is completed, the liability is reduced. This is done by debiting deferred revenue and crediting income. In this way, the deferred revenue amount is moved from a liability to income.
Once the project is complete, all deferred revenue is moved to the income account.
How deferred revenue shows up on the balance sheet
Deferred revenue shows up on the balance sheet as a liability because the work has not been performed yet. Since it’s possible that the work will never be performed — whether canceled by the customer or by other circumstances — and the money would have to be paid back to the customer, it is considered a liability.
The terms of the contract will dictate whether it’s a current or a long-term liability on the balance sheet. If the project is expected to be completed within a year or less, it is considered a current liability. If it is a multi-year project, then it will be recorded as a long-term liability.
As work is completed on the project, the amount of the liability will be reduced, until it is complete and there is no more deferred revenue. The income will show on the profit and loss or income statement in the same way, as the work is completed.
Examples of deferred revenue in construction
Let’s look at a couple of examples of recording deferred revenue in construction. The first involves accepting a deposit for a project, and the second regards prepaying for custom materials.
Example 1 – Contractor
A home remodeler receives a 10% deposit on a $100,000 remodeling project, which is expected to take three months to complete. The remodeler records the receipt of the deposit by debiting their bank account and crediting a deferred revenue account (a liability).
The journal entry will look like this:
Bank account: $10,000
Deferred revenue: $10,000
In the first month of the project, one-third of the work is completed. This means the deposit income has been fully earned.
The remodeler must make a journal entry to move the deferred revenue to income from sales. To do this, they will debit deferred revenue and credit income from sales (see entry below):
Deferred revenue: $10,000
Sales income: $10,000
With this entry, the deferred revenue account has a zero balance, and the work has been recognized as income.
Example 2 – Material supplier
A supplier of custom materials has signed a purchase order for $1,000,000 in materials that are to be provided over four months. The terms of the agreement state that the purchaser must prepay for all materials before production begins. Once the supplier receives the payment, they record the deferred income by debiting their bank account and crediting a deferred revenue liability account:
Bank account: $1,000,000
Deferred revenue: $1,000,000
The first month, delivery of one-quarter of the materials is made. To record the income, the supplier makes a journal entry debiting deferred revenue and crediting sales income:
Deferred revenue: $250,000
Sales income: $250,000
The balance in deferred revenue is now $750,000, the value of the materials still to be delivered, and $250,000 in income has been recognized.
The second month, another quarter of the materials are delivered, so the supplier makes the same journal entry. This brings the balance in deferred revenue to $500,000 and recognized income to $500,000.
Let’s say there’s a problem with the project and the purchaser cancels the rest of the order. The supplier now owes the purchaser the remaining balance of deferred revenue because the work has been canceled.
To record the refund and clear out the liability, the supplier will credit their bank account and debit the deferred revenue account:
Bank account: $500,000
Deferred revenue: $500,000
This leaves the deferred revenue account with a zero balance, and the income earned for the project shows up in the sales income account.
Record deferred revenue carefully
Many contractors and suppliers request deposits from their customers to help with cash flow. This deferred revenue must be recorded correctly on the company’s financial statements, or they could be overstating their income. Deferred revenue should be recorded as a liability, with periodic entries to recognize the income as the work progresses.