The goal of a business is to make more money than it spends, which is the profit. However, profit is not the same as profitability, though the two terms are used interchangeably very often. Profit is the amount of money that the company has after paying the expenses. But, profitability in business is the return on investment that the company makes. A profitable company may not be showing profits. This scenario happens when the company reinvests all its money to grow bigger. So, there is no profit left after expenses though the company is showing an excellent return on investment. So, to analyze a company and its performance accurately, one must clearly understand the terms profit and profitability and how they differ.
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The company’s financial records will clearly state its income and its expenses of the company. When there is a higher income than expenses, the company makes a profit. This number is calculated on the income statement, and it is a crucial metric to keep track of. So, profit is a precise and directly computed number. Profitability in business is more relative. It is the ability of the company to generate a return on investment with its available resources when compared to another company or project. So, a company that is generating a profit may not be classified as profitable.
So, profit and profitability through similar, must not be confused with each other. The profit tells you how much the company has gained in terms of money after its expenses. Profitability is a measure of the success or failure of the business's ability to make a good return on the money invested in it. It is not a specific amount of cash but uses different profitability ratios.
Profit and profit margins are vital to a business. The profit is the amount of money that is left over from the revenue after the company has paid for its expenses. It is mathematically computed as the difference between the revenue and expenses and is found on the last line of the income statement. Hence it is called the ‘bottom line’. The profit made is essential for the company to keep itself in business and to have enough money to expand and grow without incurring debt. Profit keeps the business solvent. A company's profit can be calculated from the cash flow statement and the income statement. The cash flow statement tells the reader how much money has come in and how much is going out in a particular time period. The difference between the two is the profit or the loss of the company.
Profit can be classified into three categories:
Profitability in business measures how well the company is making returns on the investment of its owners or stakeholders. In a public company, the shareholders observe the profitability of a company to see if they are making a good return on investment (ROI). The profitability measures how well the company is using the resources that are available to it to make money. This includes the assets that it has, such as factories and equipment. The profitability of the company is not the same as the profit. Certain companies reinvest their profits back into the company to expand. So if they are making a profit but are not profitable, they are not serving the purposes of the owners' and shareholders’ investments well. Profitability is very important in companies that are using capital or debt to grow their operations.
We can calculate and measure profitability using profitability ratios such as the return on assets (ROA) or profit margin ratio. This tells us the ratio of the company’s profit compared to the total costs such as equipment, inventory, and supplies. If the ROA is low it means that the company is making too little money compared to what is invested in it. It is not making the owners enough money for their investment, and this may result in fewer investors willing to put their money into the company.
The profit of the company can be the net profit or loss. This is because if there is leftover money after expenses, it is a net profit. But if the expenses are more than the revenues, it is a net loss. The formula for the profit of a business can be calculated from the numbers on the income statement. It is as follows:
Profit = Total Revenue – Total Expenses
This number is calculated and displayed on the bottom line of the income statement. A negative shows that it is making a loss and that corrective measures are called for in order to turn the company around.
We can take the example of a company that generated INR 22,000 in revenue in December and spent INR 12,000 on expenses. The profit would be the difference between INR 22,000 and INR 12,000, which amounts to INR 10,000. This is a positive number which indicates that the company made a net profit of INR 10,000. But, that profit does not indicate that the company itself is profitable. Profitability in business looks at the overall picture of the money that the company is making and compares it to the investment that was made in the company. The most popular profitability ratios that are used for this purpose are:
Profit margin ratio: This is the number that is the most similar to the profit calculation and tells you the difference in the expenses and profits called the profit margin. It is not a number but a percentage. The numbers used to calculate the profit margin ratio are usually found on the company’s income statement. The formula is:
Profit Margin = (Revenue – Expenses) / Revenue
If we use the same example as we did for profit, INR 22,000 is the revenue, and INR 12,000 is the expenses.
So, profit margin = (INR 22,000 – INR 12,000) / (INR 22,000) = 0.45
The profit margin is 0.45 or 45% which means that the company is making 45 paise for every rupee of revenue. A profit margin over 25% is good.
Gross margin ratio: The gross margin ratio compares the gross margin with the net sales. It helps understand how much higher you have priced your products compared to their cost price. So, it is the amount left when you subtract the COGS (Cost Of Goods Sold) from the revenue. The COGS is the amount that is spent to produce the goods sold. The gross margin ratio formula is:
Gross Margin Ratio = (Revenue – Cost of Goods Sold) / Revenue
So if the revenue is INR 22,000 and the cost of goods sold is INR 10,000, we calculate as follows:
Gross Margin Ratio = (INR 22,000 – INR 10,000) / INR 22,000 = 0.54
So the gross margin ratio is 0.33 or 33%. This indicates that the company has 33% of the revue left after spending on expenses.
Return on investment (ROI) ratio: this is the profit of the business compared to the amount of money invested in the business. It tells you your return on investment and is of particular interest to shareholders.
The formula for ROI is:
Return on Investment = (Gain from Investment – Cost of Investment) / Cost of Investment
Let us say that INR 1,000 is spent to market a product that generates INR 1,500 in sales.
ROI= (INR 1,500 – INR 1,000) / INR 1,000 = 0.5
So, the return on the investment of every INR 1 is returning 50 paise. The higher the resulting percentage, the better the profitability of the company.
Profit and profitability are not the same in accounting. A company can generate profit and not be profitable. So, the difference between the two should be well understood. Profit is the amount that the company has left over after paying the expenses. Profitability is how well the company is using the resources that it has in hand to generate revenues. It tells the shareholders how much return the company is giving them for their investment.
The profit a company makes is the difference between the revenue and expenses of the company. A company can make a profit but how profitable it is, depends on comparing its profits to the resources that were used to generate the revenues. The owners and the shareholders of the company put money into the enterprise with the hope that it will give them returns on their money. So the profitability in business gives an indication of whether the company is delivering on this or failing at it.
Investors look for high profitability companies to invest in. This is because these companies are using the money that they have in the form of resources to make the most money. The company that uses its human resources, machinery, and infrastructure to make the most money is a promising investment. When investors compare a highly profitable company to one that is just breaking even, the profitable company is more attractive. Profitability is a reliable measure of a company’s performance regardless of its size and scale.
Profit is the short-term status of the company’s bottom line. It is the short-term income status of the company. Profitability, on the other hand, is a more important long-term metric that is of interest to investors. While the profit calculation gives an indication of the bottom line, the profitability is the measure of the return on investment of the company.
A profitable company is very attractive to investors because the company is making the maximum use of its resources to generate more money. A profitable company will easily attract more new investors to help fund its further expansion and growth. Higher profitability shows the company is more likely to continue keeping the stock and dividend value high. Sustained performance and profitability is more important to investors than profits in the short term.
The ratio of the company’s profits over the investments made in it is the profitability ratio. If the ratio is high, it means that the company is doing well. This ratio can be measured as the net profits divided by the total assets of the company. Most companies that are publicly listed declare their profitability ratios as this is of great interest to the investors. However, other smaller companies must also keep a watch on their profitability ratio.
Generally, a profitability ratio of more than 10% is good because it shows that the company is doing more than merely breaking even. The company is making the best of all the resources at its disposal and building a strong business foundation. Profitable companies usually reinvest their earnings in the company to fuel further expansion and growth.
Lenders and investors alike monitor the profitability of a company to determine if the company will be able to repay its debts. Calculating profitability is important for businesses. But smaller businesses and family-owned businesses may find it difficult to calculate their investments and assets accurately. TallyPrime helps you monitor your company’s performance instantly regardless of the company’s size. Keeping profitability in mind helps long-term planning and reinvestments in the company’s growth.
Accounting is an essential part of running a business of any size. Most accountants maintain accounts strictly adhering to the commonly accepted accounting principles and regulations. However, within the accepted principles there is some flexibility in the methods of accounting that a business uses. One of the preferred and most popular methods is the cash basis accounting method. It is very straightforward and easy to understand and implement. The cash basis accounting method recognizes the receipt or payment of cash as it happens. This is one of the main reasons why it is easy to implement even with users and businesspeople who have little accounting knowledge. Read on to understand what is cash basis of accounting.
Cash basis accounting is the method of accounting that records the payment and receipt of cash as it happens. It is the simplest form of accounting that is often used in small businesses and proprietorships because of its ease of use. It is especially easy to implement in a business that has no inventory.
The alternative system of accounting is the accrual basis of accounting that matches the revenue and expenses and records the expenses and revenues within the same accounting period. The recording of the revenue and expenses does not always happen when the cash is paid or received. The cash paid or received without the matching counterpart of revenue or expense is recorded as a deferred entry that is later adjusted. While smaller businesses are able to maintain accounts records easily with the cash basis of accounting, they often adopt the accrual-based accounting when they grow in size. When you work with TallyPrime to manage your business accounting, you will be able to work with either cash-based or accrual-based accounting effortlessly.
Cash basis accounting is useful because of its simplicity, but it has many drawbacks. The accrual-based system is more complex but is also widely used. The revenues or expenses are recorded only when they are matched with their counterpart and not at the time when the actual cash transaction takes place. Since the cash basis shows the actual cash position and not the revenue that has been earned, it can give a falsely positive picture of the finances of the system. The accrual system gives a more realistic picture of the company’s finances, revenue, and income. The accrual system gives a more complete balance sheet. This is because the net income for a cash basis accounting system is based only on the cash received, but that of the accrual system is based on the revenue and not the cash received. The accrual system follows the matching principle of GAAP and is a better system for large organizations and businesses with inventory.
Let us take the example of a company that has been awarded a huge maintenance contract. The terms of the contract state that they will be paid in one payment after the end of the one-year contract period. In this scenario, the company would be performing the service throughout the period. By the cash basis accounting system, they will only record the payment for the service at the end of the year when they actually receive it. So, for the entire contract period, the books of accounts would show that the company is not generating revenue.
If we take the opposite, the company may receive a huge advance payment for a long contract of a year. They will record the revenue when they receive it at the beginning of the contract period. Throughout the rest of the period, the accounts will only show the expense of the project and it would appear that there is no revenue. If the cash payment falls outside the accounting year, the company’s books of accounts may show a very misleading picture of the company being idle for the year when in fact, it has been working on a lucrative contract. The books of accounts may even show a loss for the year.
Easy to use: Most small businesses have limited staff. The owner of the business usually handles the accounting of the business as well. Cash basis accounting is very simple to maintain because it tells the owner exactly how much cash there is on hand, and it is a very easy method. Since cash receipts and payments are recorded as they happen, there is no need for an accountant to manage the business accounts. Many simple software programs are able to handle the easy cash basis system of accounting. TallyPrime can be used in a simple cash basis accounting application just as efficiently in a more complex accrual-based accounting system.
Tax: Some accountants prefer to use the cash basis system of accounting because it may offer tax benefits by accelerating some payments and reducing the taxable profits. So, it is applicable in cases where it can be used to defer tax liability.
The cash-basis method has some inherent disadvantages.
Can be misleading: a company may have a decline in business orders for one month. But, if many customers make payments in that time period, it will give a false picture of a boom in business. The cash basis accounting system only reflects the cash status of the company and cannot be relied upon in order to judge the actual revenue and expense that the business is generating. Using such trends for analysis, projections and planning will give highly inaccurate results.
Accuracy: The timing of the cash payments and receipts may not exactly match the actual revenue generation and expense activities. So, if a company is spending toward a project that will only pay at the end of the period, the records will only show the expenses without the revenue that is being earned through the expensing activity. This is the picture that the books of accounts will present until the company finishes the project, issues the invoice, and collects the payments.
Easy to manipulate: A business can alter its results by not encashing a cheque immediately or by manipulating the cash receipt payment. The tax component of the income then gets deferred to the next accounting period.
Raising funds: Since many financial institutions do not rely on cash-basis accounting, a business following the system may find it hard to obtain a loan. However, small businesses and proprietorships may not be subject to such stringent rules.
Auditing: If a business wants to start auditing its accounts, it would have to switch to the accrual-based system of accounts. Auditors will only issue audited financial statements for companies that maintain their financial records with the accrual-based accounting system.
Reporting: The reports of the cash-based system are highly unreliable and cannot be used to track and analyze the company’s performance or finances.
These disadvantages are the reasons why most companies switch to accrual-based accounting as they grow in size. Intelligent accounting software such as TallyPrime helps even small businesses to take advantage of the cash accrual system of accounting.
To choose between the cash basis accounting and accrual-based accounting systems, we must first understand what is cash basis of accounting and its feature comparison.
Feature | Cash Basis | Accrual Based |
Ease of use | Very simple and straightforward to use | More detailed and complex to understand and use |
Timing | Revenues and expenses are recognized when cash is received, or paid | Revenues and expenses are recognized only when they are earned |
Management of credit | Accounts receivable and payable are not maintained | There is a record of the receivable and payable which gives a complete picture of the finances |
Net income calculation | Net income is calculated based on the cash that flows in and out. Can be very inaccurate | Net income is calculated by factoring the precise revenue and related expenses, which is more accurate |
GAAP | Does not follow the matching principle of GAAP | Follows the GAAP matching principle |
Application | Is easy to use in personal accounts, small proprietorships, and small-scale businesses | Is used by large organizations that need to file audited financial reports, and statements |
Another term that is used for cash basis accounting is cash accounting.
Cash basis accounting is best for a business that needs to track cash and record transactions simply. It is not suitable for a business that has inventory, loans, or long-term liabilities.
Despite its shortcomings, cash basis can be used for certain applications. It is primarily suitable for small, simple businesses that do not have inventory. It is also suitable for small associations and non-profit organizations.
Cash basis accounting is best suited for businesses that have the following features:
TallyPrime is the best choice of accounting software for small simple businesses and more complex accrual-based accounting systems. It allows you to grow your business and switch your method of accounting without having to reinvest in new software. The design and layout of TallyPrime easily reflects all your transaction entries in the correct books of accounts. Tally allows you to maintain your daily accounting records with minimal fuss and without the need for an accountant. It also makes auditing by an accountant easier and quicker.
Business accounting is an essential component of managing and running a business whether big or small. Accounting is the process of recording and keeping track of the money that flows through the business. Controlling money is only possible when you are able to keep track of how it is coming in and the ways in which it is spent. Tracking cash flow is especially important in a small business that has limited resources and must use them optimally.
If you are a new business owner, it is especially important to grasp your business finances. This is because most new businesses run into trouble when they face a cash crunch. You can control your company's cash flow when you can clearly visualize it. Small business accounting fulfills this need by allowing you to view your business’ cash status and also generate reports that summarize the transactions of a specific time period.
Small business accounting is the maintenance of complete and accurate records of all the financial transactions of the company as well as extracting the relevant information from the system when required. This may be easy for the business owner to do when a business is new, but, as the business grows in volume, the volume of financial transactions also increases.
Every business must maintain records that detail all the income, expenses, assets, liabilities, and essential details such as payroll. Additionally, the business must issue bills, invoices, and other documents. Financial reports that are required by government authorities and financial institutions must also be accurately generated and filed. The calculation of taxes and other payments required by government regulation can only be performed accurately when there are complete and accurate records. Business accounting also helps business owners and managers monitor their business’ performance.
At the end of the financial period or financial year, the entire business accounting data is summarized and important financial reports such as the balance sheet, income statement, and cash flow statements are generated. These statements may be necessary for submission to investors and financial institutions.
Assets: Any resources that a business owns that can produce economic value is called an asset. An asset can be tangible or intangible. Tangible assets are physically present and owned by the business, such as the premises, factory, or equipment. Intangible assets do not exist physically but still, have value. Some examples of intangible assets are brand names and intellectual property rights. Assets can be converted into cash, and cash itself is an asset. The company’s assets are all listed on the balance sheet, and they are ordered in the order of how easily they can be liquidated.
Liabilities: Anything the company owes to others is listed as a liability. This includes loans, mortgages, legal obligations, taxes, payroll, accounts payable, and other such accounts. The amounts that the company owes in the short-term such as accounts payable are called current liabilities, and the ones that are not due for more than a year are the long-term or non-current liabilities. Non-current liabilities are usually listed on the balance sheet.
Shareholders' equity: The money that the owners of a company have invested in the company or that is held by the company’s retained earnings is called the shareholder’s equity. This is inclusive of retained earnings, common shares, and preferred shares. In a private company, it is called owner’s equity. The value of equity is calculated as the money that would be paid to the shareholders or owners if the company were to be liquidated (after settling all liabilities).
Revenues and gains: Revenue is the money that companies make through their primary activities. Gains are the money that the company makes through sources that are not a part of the normal activities. For example, the sale of a capital asset such as property, stocks, or bonds for more than you bought it for is a capital gain.
Expenses and losses: Expenses and losses are two terms that mean very different things. Expenses are the costs that are spent on the activities that generate revenue. Losses are the money that the company loses through an action that is not a part of its primary activity.
Net income: It is also referred to as net earnings. It is calculated as the sales minus the COGS (cost of goods sold), expenses, taxes, and interest. It indicates if the revenue exceeds the company's income, which is its profitability. It is used to compute the earnings per share or pre-tax earnings.
Operating activities: The primary activities of a company that are performed in order to provide its goods or services are the operating activities. These activities usually keep the company's cash flow going and are inclusive of manufacturing, marketing, advertising, distribution, etc. The operating activities of the company influence the profitability of the company.
A company can include paying suppliers, paying taxes, receiving payments from goods sold, payroll payments, and such daily activities as their operating activities. Business accounting records show most operational activity-related financial information on the cash flow statement and income statement. Any other activity unrelated to the company’s primary operations, such as the issue of stocks and bonds, etc., are not operational activities.
Investing activities: A business activity such as buying a long-term asset is an investing activity. These assets are usually capitalized after one year. The cash flow statement also shows investing activities as a capital expenditure.
Financing activities: Activities such as debt financing, initial public offerings, secondary offerings, repurchase of shares, cash paid for dividends, etc, are called financing activities and are separate from the operational activities of the company.
Open a bank account: The first step to small business accounting is registering the business or company. After this, you would need to open a current account in a bank to store and transact your business’ money. It is always a good practice to keep your business account separate from your personal account to calculate taxes accurately and have a hassle-free business accounting experience. This may also be a requirement legally for certain types of businesses and companies. Even if you are the sole proprietor of your business, your life will be so much easier when you keep your business and personal accounts distinct from each other.
You may also want to set up different accounts for different purposes. For example, your primary business account could be for the daily business activities while another may be used to save the tax payable and other withheld amounts until they are due to be paid. Choose a bank that gives you the maximum benefits at the minimum cost. A bank that has lower charges for a business account is always a good idea. If you do a lot of your business online, extra benefits for online transactions and payments are essential. A net banking interface that is easy to use and seamless integration with card machines are added benefits. The requirements, documentation, and fees vary by bank, so do your groundwork before you open the account.
Have a business software like Tally: A small business can maintain its accounts manually when it starts up. Then as the volume of the transactions goes up, it becomes a hassle to keep up with the recordkeeping. When it is time to file taxes or generate a report, the services of an accountant would be needed. Business management software used at the very beginning is the right way to start. It may be tempting to buy a single module software and then buy other modules later. But, the reentry of data in different systems may be more labor and time-intensive.
An integrated accounting solution such as TallyPrime is ideal for small business accounting. It also works just as well when your company grows. The integrated modules save you time and also allow you to generate accounting reports using all your financial accounting data in one place without data re-entry. Reports for tax filing and other repetitive tasks will be effortless and may not need the services of an accountant. If you are a business owner who is not an expert accountant, TallyPrime also ensures that the transaction entries are entered into the right books of accounts without accounting mistakes.
Set up a payroll system: A small business may have a very minimal payroll. But as the business grows, so will the headcount. You may also need to employ temporary or contract staff for one-time jobs. Payroll software helps you calculate and record payroll and also stay compliant with regulations and taxes. You have a well-organized payroll that is integrated with all the other accounting modules and also updates the other books of accounts that are implicated in a payroll payment.
Investigate import tax: If you are going to import goods or services as a part of your business, understanding the import regulations and taxes applicable is essential. Ensure that all your imports are compliant with the regulations and that the essential documents are prepared in the correct format and manner. TallyPrime helps generate all the required paperwork in physical or digital format as required. It also generates the appropriate taxation calculations and reports.
Determine how you'll get paid: Collection of payments is an important step in a business. A business that has multiple payment options is more attractive to the customer. Explore the payment options that are available to you both offline and online. Set up your payments so that your customer has the minimum number of steps before payment. Choosing a bank that supports the maximum payment options is an important decision. Negotiate and select payment service providers that offer maximum safety and minimal charges. Customers prefer a payment gateway that they can trust. Small business accounting software that can accurately record multiple payment methods is essential.
Establish sales tax procedures: Computing, collecting, recording, and filing taxes is an ongoing process in a business. Accurately calculating taxes and filing them on time is vital. TallyPrime makes filing taxes effortless by generating the reports in the required formats with all the relevant information extracted from the transaction records. If your business imports or exports goods and services, additional reports and filings will be made.
Determine your tax obligations: The tax obligations that a business is subject to depend on the goods or services that they sell. Get a clear understanding of how much tax you are liable to pay and the tax component of your invoices. This will prevent you from making costly mistakes in the future. Accounting software that lets you analyze your transactions and generate multiple tax analysis reports helps you assess and keep an eye on the tax amount that you are obligated to pay.
Calculate gross margins: Analyzing your accounting data is important to ensure that your company earns as much as it can. Analyze the gross margin that your business is earning with your business accounting data. To calculate this, you must first understand the terms Cost of Goods Sold (COGS) and gross margin. The Cost of Goods Sold (COGS) is the company's costs to produce the goods for material and labor, and the gross margin is the total sales revenue left after the direct costs incurred to make the product or service.
The formula for gross margin is:
Gross Margin (%) = (Revenue - COGS) / Revenue
So the gross margin is the amount that the business makes after the sale of its goods and services. It is essential to make a gross margin that is large enough to keep your business in good financial health and turn a profit.
Periodically re-evaluate your methods: The accounting methods you use should be assessed periodically to determine if it is the right match for your business. If you are having to continually transfer data, re-enter data or manually generate and edit forms, you may need a better option. TallyPrime is integrated so that there is no data reentry at all. The reports generated are fully compliant with the official requirements and need no rework. The time saved is equal to money saved for the business. The time saved by using an intelligent accounting system is better used in business activities. Good bookkeeping also keeps your business fully compliant with the legal requirements.
An agile and transparent accounting system with excellent data analysis and reporting gives you the tools that you need to make your business successful. It is not always easy to extract different reports and analyses quickly from a manual accounting system. An accounting system that helps you see the numbers, trends, and patterns in your finances help you make informed business decisions and strategize better.
When a company collects payment in advance for a product or service that has not been delivered, it is called deferred revenue. The treatment of deferred revenue in business accounting is different from a payment that has been made after delivery. This different treatment occurs when the revenue is earned in one accounting period, and its delivery is in a future accounting period. This presents a unique situation in which the accountant will have to treat the revenue differently when preparing the business financial reports and statements.
Deferred revenue is also called unearned revenue because it is a revenue payment that is received before the company has earned it by delivering the product or service. This presents a unique situation when the company uses accrual accounting. Accrual accounting requires that the revenue and matching expenses should be accounted for in the same accounting period. But when a company receives an advance in one accounting period and then delivers the goods or service in the next, there is no match of the revenue and expenses. When you receive a retainer or a booking amount for a service or product, this situation arises.
Accrual accounting recognizes a payment receipt as revenue only when earned. In reality, customers often make advance payments towards goods and services that have to be recorded in the books of accounts. So, instead of recording this deferred revenue as sales revenue, it is listed on the balance sheet as a liability and not recorded in the income statement.
Since the deferred revenue payment is received for a service or product that is yet to be delivered, it is a payment for something owed to the buyer or customer. This makes it a liability rather than revenue. As the product or service is delivered in portions or completely, the appropriate amount of deferred revenue is recognized on the company’s income statement. This is in line with the GAAP guidelines for accounting conservatism.
The balance sheet records the deferred revenue amount as a short-term or current liability as the service or product that is paid for is expected to be delivered in the short term. So, it is a debt that is owed to the customer or buyer. If the service or the product is not delivered, the money may be liable to be returned. The collection of the amount also means that the company owes the service or product to the buyer.
There is a difference between the deferred revenue and accrued expenses. They are both listed as a liability on the balance sheet. But deferred revenue is money received in advance for services/products not yet delivered, and accrued expenses are amounts for which the company has received services/products and has not paid for as yet.
An example of this could be a performance bonus that an employee who performs well earned every month. The amount is calculated and adds up but is only paid at the end of the defined period. Since the amount owed increases over time, it is an accrued expense and not a deferred revenue.
Deferred revenue is categorized as a liability on company balance sheets. This is because the company has received the deferred revenue amounts as an advance. The company is then liable or obliged to deliver the service or product that the advance was paid for. If the company is unable to deliver the service or product, it may be liable to repay the amount that was collected as an advance unless there are other terms and conditions agreed upon in the contract between the buyer and seller.
Deferred revenue is unique to accrual accounting systems where there must be a matching of the expenses and revenues that relate to each other. However, if a business uses cash basis accounting, there is no worry about deferred accounting. The money you receive is recorded as soon as you receive it, and there is no need for any other adjustment or matching principle. You record the transaction exactly when it happens.
In accrual accounting, the receipt of payment can only be recognized as a revenue payment when the company has earned it. So, when an advance payment has been received, it is recorded as deferred revenue. When the company performs the actions that earn that revenue, it gets recorded as revenue, and this is called revenue recognition. The principle that states when money can be recorded as revenue is called the revenue recognition principle. The revenue recognition principles that are defined by Generally Accepted Accounting Principles (GAAP) for different business types and industries are the most commonly followed principles.
The principle of deferred revenue may be confusing to some as it uses the word ‘revenue’ but is classified as a liability. This is because the money has not been earned yet. It is an amount that is liable to be returned in case the company is not able to deliver the product or service. Some industries have very strict methods and principles by which they put aside the deferred revenue until it is earned.
The principle of deferred revenue is useful to prevent overvaluation of the business by including payments for deliverables that haven't been delivered yet. For example, a yearly subscription service may collect the entire yearly subscription upfront, but the services will be delivered over the next year. By using the deferred revenue system, the company’s accounts present a realistic picture of what it is actually worth and how it is performing through the year. It is also good accounting practice to be very discerning about the amounts that are classified as assets and liabilities on the financial records. Following the accounting principles ensures that liabilities such as the deferred liabilities are not misclassified as cash.
Deferred revenue is easier to understand with an example that shows each step and entry that is made.
A company agrees with a client to deliver a service for the next 12-months and collects the entire annual fee of $1200 upfront. So the company records a revenue of $0 for the month but creates an entry for the liability in the deferred revenue account amounting to $1200. The cash amount on the balance sheet increases by $1200.
Account | Debit | Credit |
Cash | $1200 |
|
Deferred Revenue (Liability) |
| $1200 |
After every month, the company records a revenue of $100, and the deferred revenue account gets reduced by $100. This recording of revenue and reduction of the deferred revenue continues for 12-months.
Account | Debit | Credit |
Deferred Revenue (Liability) | $100 |
|
Revenue |
| $100 |
At the end of the 12-month agreement period, the earnings or revenue of the company would have shown the entire $1200, and the deferred revenue from that particular transaction will be $0.
By the principles of accrual accounting, it is necessary to record deferred revenue when money is collected in advance of the product or service being delivered. It is recorded as a liability until the product or service has been delivered. If the product or service is delivered in installments, the proportional installment of the money recorded as deferred revenue is transferred to the company’s revenue account.
Cash basis accounting does not follow this principle and records the money as it is received. This is easier to maintain when customers are very volatile and changeable in their payments. However, it can artificially inflate the company’s value by showing such advance payments and subscriptions as revenue when they are yet to be earned.
The deferred revenue principle also affects the cash flow statement. This statement would record the payment in the example above as cash from operating activities on the date when it was received. No adjustment entry is made in the cash flow statement.
