Deferred revenue is considered a liability to companies that contain them. It occurs because a customer has paid for a product or service, but the company has yet to provide the product or perform the service.
Deferred revenue means that a company may have received a form of payment, but recognizing the revenue would inflate revenue as well as the net income. This is because the company has not incurred its cost for the payment received. This is why accounting for this type of revenue requires that the payment amount be considered a liability and is put into the deferred revenue account. Once the product or service has been provided then the company can reduce the liability and recognize the revenue.
For example, Widget Co. buys it supplies from Wawadoo Co. Often times Widget will buy the supplies through a contract at an established price. This allows the two companies to smooth out their earnings and removes some of the volatility in the market. Widget even sends payment a month in advance on what it foresees demand to be that month. This payment requires that Wawadoo record deferred revenue on its books until it provides the supplies that Widget company needs. Once the supplies are sent to Widget Co., Wawadoo records the revenue and cost of the sales. The company will also reduce the amount of revenue deferred as it earns more of the pre-paid cash.
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