What is Deferred Income?
A business generates deferred income, sometimes called “unearned income”, when it receives payment in advance for something it has not yet delivered. Officials consider the income “deferred” because the business has not yet earned it by fulfilling its obligations.
This concept is based on the Revenue Recognition Principle. According to this principle: businesses should only count money as income when they’ve actually earned it by delivering the goods or services – not when the payment comes in.
For example: A business receives payment upfront for a year-long service. Even though they’ve received the money, they can’t count it as income immediately because they still need to provide the service throughout the year.
How to Account for Deferred Income
Accountants treat deferred income as a liability because the business has an obligation to deliver goods or services in the future. However, until those goods or services are provided, the money technically doesn’t belong to the business.
Let’s breakdown how this works:
- When the business receives payment, it records the amount as a liability on its balance sheet. This shows that it still owes the customer either goods or services.
- As the business delivers goods or services, it gradually reduces the liability and recognises the corresponding income. This approach ensures the financial statements display earnings at the correct time, instead of when the payment was first received.
Deferred Income and Taxes
Deferred income also impacts taxes, but deferred tax is a slightly different concept. This occurs when there are differences between how a business accounts for income and how the tax authorities treat it.
One common example involves depreciation. A business might record the cost of an asset in different ways for its accounts and tax purposes. This approach creates differences in how much profit the business reports, resulting in either a deferred tax liability or a deferred tax asset.
- A deferred tax liability occurs when a business pays less tax now and expects to pay more tax in the future due to differences in how accounting and tax rules treat income or expenses.
- A deferred tax asset arises when a business pays more tax upfront and expects to benefit from future tax relief as the timing differences between accounting and tax rules resolve.
Why Does Deferred Income Matter?
Understanding deferred income gives a more accurate picture of a business’s finances. Recognising income only when they earn it helps businesses avoid overstating their earnings. This approach helps investors and lenders get a clearer view of how the company is performing.
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