When a customer pays in advance for a product or service such as a prepaid insur

Question

When a customer pays in advance for a product or service such as a prepaid insurance policy, the business that sold that item will record the cash received as an asset and the future obligation to provide the item as a liability. Please give some thought to different business situations where the customers may pay in advance and provide an example here.

1. Using your example, which account is debited to record the payment received? Which account is credited?

2. When the business provides the product or service, which account is debited? Which account is credited?

3. What do we mean by the term “deferred revenue”?

4. How would these transactions be recorded under the cash basis of accounting? What are the benefits of recording the deferral under the accrual basis?

Explanation / Answer

Let us assume a business scenario where a company providing service of managing the IT network of clients. The company entered into a contract with a client for IT network maintenance from Jan to Dec next year. The contract signed in previous year December and advance payment for full year also received in December.

In this case Cash A/C will be debited with the advance payment and Unearned Service Revenue A/c will be credited as liability account with the same amount.

When business provides service next year , after the end of each month , 1/12th of the total amount will be credited to Service Revenue A/c and debited to Unearned Service Revenue A/C.

The term deferred revenue is used when payment for goods or service received in advance but the goods and service has not been provided to the customer. As per revenue recognition principle, revenue can be recognized when title of goods transferred to customer or complete service has been provided, the cost and revenue can be estimated and there is reasonable certainty that revenue will be realized. In advance payment without goods of service provision , the revenue recognition criteria are not fulfilled, so the payment received is set off against adeferred revenue liability account. When goods or service are provided, the revenue is credited and deferred revenue debited to recognize revenue.

In cash basis of accounting there is no deferral or accrual concept. So revenue is recognized at the time of advance payment receipt though goods or services not provided at that time.

The deferral system actually conforms to the matching concept of accounting which stipulates that the revenue and cost of a same period must be recognized together. If there is mismatch in periods of revenue and cost recognition, the financial statement gets distorted with abnormal profit or loss in different periods. Therefore deferral and accrual concept are fundamental principles of accounting.

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