What Is Deferred Credit?
A deferred credit is money that is received by a company but not immediately reported as income because it has not yet been earned. Under the accrual accounting method, revenues can only be recognized as earned when the product or service paid for by a customer has been delivered to him or her and the proceeds can be matched with a related expense.
Deferred credit, also known as deferred revenue, deferred income or unearned income, is recorded on the balance sheet as a liability. Items that fall under this category include consulting fees, subscription fees, and any other revenue stream that is intricately tied to future promises.
- A deferred credit is income received that will be recorded at a later date, under accrual accounting standards.
- Most companies only recognize revenue when the product or service paid for by a customer has been delivered and the proceeds can be matched with a related expense.
- Until the company fulfills its obligation and the chance to renege on an order is ruled out, the payment is recorded on the balance sheet as a liability.
- Deferred credit is mainly used as a means to even out, or "smooth" financial records and give a more accurate picture of business activities.
Understanding Deferred Credit
In most cases, a deferred credit is linked to advance payments. The customer pays the seller for a good or service that is scheduled to be delivered or performed in the future. This may also be known as a deferred revenue.
As the company has yet to provide something in exchange for the money it’s just received, it will usually record the payment as a current liability on its balance sheet. The payment is considered a liability because it represents an obligation. Work still needs to be done to earn that money, and there's a possibility that the good or service won't be delivered, or that the buyer cancels the order, in which case the company may then need to reimburse the customer, depending on the terms explicitly stated in a signed contract.
Under the accrual accounting method, the standard accounting practice for most companies, revenue is only recognized as earned when the goods or services are delivered to the buyer — and not when they are paid for.
Only when the seller has provided the services or shipped the merchandise it has already been paid for can it record the money it initially received as income. At this point, the deferred credit is recognized and the liability is removed from the balance sheet.
Benefits of Deferred Credit
If, for instance, all of a company’s membership or subscription fees just happened to come in during the first quarter and all products were then shipped out in the second, the quarter-to-quarter income statement would obviously be skewed.
Example of Deferred Credit
XYZ Corporation sells book club subscription services. Members pay an all-inclusive fee upfront that includes charges for a book of the month and related shipping.
Members pay for the year's subscription in advance. When XYZ Corporation collects the payments, they mark a deferred credit liability on their balance sheet for the full amount. As the books are delivered, the revenue for that delivery is recognized and the amount of the deferred credit liability is decreased by that amount.
Deferred credit is usually recorded on the balance sheet as a current liability because most prepayment terms are typically for 12 months or less. However, in some scenarios, it is possible that a customer makes an up-front prepayment for goods or services that are scheduled to be delivered over a longer timeframe, such as with a multi-year subscription service.
In these cases, any item already paid for that is expected to be delivered or rendered after more than a year should be classified under the long-term liability section of the balance sheet.