Deferred Revenue Expenditure

25/07/2020 1 By indiafreenotes

In business, Deferred Revenue Expenditure is an expense which is incurred while accounting period. And the result and benefits of this expenditure are obtained over the multiple years in the future. For example, revenue used for advertisement is deferred revenue expenditure because it will keep showing its benefits over the period of two to three years. Thus, the profit and loss account statement is prepared as a periodic statement.

Deferred Revenue Expenditure 

Capital expenditure leads to the purchase of an asset or which increases the earning capacity of the business. The organization derives benefit from such expenditure for a long-term.

For example, the purchase of building, plant and machinery, furniture, copyrights, etc.

On the other hand, revenue expenditure is that from which the organization derives benefit only for a period of one year and it only helps in maintaining the earning capacity of the business.

For example, the cost of raw materials, labour expenses, depreciation on assets, etc. However, there is also one more category of expenses, often referred to as Deferred Revenue Expenditure.

These expenses are revenue in nature but the business derives benefits from these expenses for a period of more than one year.

Though the benefit of these expenses lasts for a number of years, these do not fall under the Capital expenditure. Because these are heavy expenses but do not result in the acquisition of an asset.

The charge of these expenses is proportionately deferred over the period for which its benefits are derived. This is as per the Matching Principle.

For example, a huge amount of advertising or marketing expenses in order to introduce a new product or to enter a new market, loss by an earthquake, flood, etc.

The practice to write off these expenses may vary from firm to firm. Usually, we write them off over a period of 3 to 5 years.

However, when this expenditure is appropriated to a specific item then it has to be written off over the useful life of that item.

Characteristics of Deferred Revenue Expenditure

  • It is revenue in nature.
  • The benefit of this expenditure lasts for a period of more than one accounting year.
  • It pertains wholly or partly for the future years.
  • It is a huge amount of expense and thus, is deferred over a period of time.

Classification of Deferred Revenue Expenditure

  • Expenses partly paid in advance: It is when the firm derives a portion of the benefit in the current accounting year and will reap the balance in the future years. Thus, it shows the balance of the benefit that it will reap in future on the Assets of the Balance Sheet. For eg. advertising expenditure.
  • Expenditure in respect of services rendered: Such expenditure is considered as an asset as it cannot be allocated to one accounting year. For example, discount on issue of debentures, the cost of research and experiments, etc.
  • Amount relating to exceptional loss: We treat the exceptional losses also as deferred revenue expenditure. For eg. Loss by earthquake or floods, loss by confiscation of property, etc.

How Deferred Revenue Works?

Deferred revenue is recognized as a liability on the balance sheet of a company that receives an advance payment. This is because it has an obligation to the customer in the form of the products or services owed. The payment is considered a liability to the company because there is still the possibility that the good or service may not be delivered, or the buyer might cancel the order. In either case, the company would need to repay the customer, unless other payment terms were explicitly stated in a signed contract.

Contracts can stipulate different terms, whereby it’s possible that no revenue may be recorded until all of the services or products have been delivered. In other words, the payments collected from the customer would remain in deferred revenue until the customer has received in full what was due according to the contract.

Generally accepted accounting principles (GAAP) require certain accounting methods and conventions that encourage accounting conservatism. Accounting conservatism ensures the company is reporting the lowest possible profit. A company reporting revenue conservatively will only recognize earned revenue when it has completed certain tasks to have full claim to the money and once the likelihood of payment is certain.

Typically, as a company delivers services or products, deferred revenue is gradually recognized on the income statement to the extent the revenue is “earned.” Categorizing deferred revenue as earned revenue too quickly, or simply bypassing the deferred revenue account all together and posting it directly to revenue on the income statement, is considered aggressive accounting and effectively overstates sales revenue.

Deferred revenue is typically reported as a current liability on a company’s balance sheet, as prepayment terms are typically for 12 months or less. However, if a customer made an up-front prepayment for services that are expected to be delivered over several years, the portion of the payment that pertains to services or products to be provided after 12 months from the payment date should be classified as deferred revenue under the long-term liability section of the balance sheet.