Deferred Revenue: When a sale becomes a liability
Have you ever been confused when someone from accounting talks about deferred revenue?
The terms ‘sales’ and ‘revenue’ are both used very interchangeably, and I think it is important for business owners to understand the difference.
A sale is when someone buys something from you. Whether it is goods that they receive right then and there, or a service you are to provide for them a month from now, the “sale” has happened when they pay you or commit to pay you.
For your financial statements, and in the eyes of the tax man, it is not so cut and dry. Revenue is different from a sale in that it encompasses all of the income sources into your business, with sales being one of the things included. For revenue recognition purposes, it does not matter when you get paid for something, revenue is recognized when you have fulfilled your obligations laid out in the sales contract.
There are two distinct commitments made when a sale occurs – the customer commits to pay you, and you commit to provide them with a good or service. The sale may have already happened, but for financial recording and tax purposes, revenue cannot be recognized until you have fulfilled your half of the transaction.
Picture this:
You are a motivational speaker and life coach. You have gained local popularity and are quite sought after. After following advice from the professionals in your life, you decided to incorporate your business to keep business finances separate from your personal finances. Business is going great, and you are booking speaking engagements up to three months in advance. It is November 17th, 2020, there is no global pandemic going on, and a huge client has just approached you to run a 5-day workshop with their employees to take place the first workweek back from holidays in January of 2021.
After negotiations, you have settled on an engagement price of $30,000 – which is agreeable to both parties. You get your engagement letter signed and the client gives you a cheque for $30,000. They clearly do not have cash flow issues, as they have dated the cheque with today’s date. You’re quite floored that they were so willing to part with this money almost a month and half before your engagement, but you don’t question it too hard and head to the bank to deposit the cheque.
Your business has a fiscal year end of December 31st, and you’ve had a great year! This $30,000 will really bump up your sales numbers and this might turn out to be your best earning year yet. You are saddened when your accountant tells you that you can’t count this $30,000 towards your income for 2020.
Why is this?
While you may have received this money in 2020, you haven’t earned it yet. The customer has not given you a boost to your 2020 sales, they have created for you an obligation to fulfill in the following year, or in accounting speak – deferred revenue. This is an account that sits on your Balance Sheet under Liabilities. What a bummer.
Your engagement contract clearly outlines what you must do for the fee of $30,000. You must conduct a week-long workshop in January. If, for some reason, you become unable to fulfill your obligation, your client will receive a refund. Whether this refund clause is included in your contract, or the client sues you to get their money back – if you do not fulfill your contractual obligation, the money is not yours.
Let’s think about this on a bigger scale. Imagine you run a ski hill and you collect almost a million dollars from customers for the following ski season. These sales go to a deferred revenue account until you start earning that annual pass revenue by conducting a ski season. As the season successfully is executed, you recognize that pass revenue as the season progresses.
What happens if we have such a warm winter that it doesn’t even snow once? As a Canadian, this almost seems like a science fiction scenario, but global warming has us able to imagine this scenario with little difficulty. If there is no ski season, you will be refunding your customers a million dollars, and those sales will not materialize into earned revenue.
It’s like the old saying “don’t count your chickens before they’re hatched”…”don’t count your revenue until it’s earned!”
Looking at this scenario from the perspective of your client:
Some might see the eagerness shown by your client as a way to “spend up the budget” for 2020. This can frequently happen in situations where people are in a ‘use it or lose it’ situation with their discretionary budget dollars. If your client also has a year end of December 31st, this could be what the intentions are.
However, just like you cannot recognize the revenue until you have fulfilled your side of the bargain, the customer cannot expense the $30,000 until they have received what they’ve paid for. Since they will not receive the service until 2021, the funds will sit on their Balance Sheet as well – as a Prepaid expense.
Deferred revenue is all around us. Gift cards are a big one. When you buy a gift card for a store, the store must record the sale in a Gift Card Liability account – essentially a differently-named deferred revenue account. It is not until the gift card is redeemed for goods or services, that revenue is recognized for the transaction value of the goods or services received.
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I LOVE banishing the “finance scaries” by teaching entrepreneurs in an easy-to-understand way. If you’re reading this, you might benefit from my FREE Financial Health Check, which will assess how you’re doing with the financial management of your business, and provide you with customized resources that will hopefully resonate with you.