What is Deferred Income?
Deferred Income is the money received by a business in advance for goods or services that it has not delivered to the customers yet. As the company still owes a product or service to its customers, it is considered a liability rather than an immediate profit.
ERP software such as Sage X3 makes recording deferred income entries much easier, accurate, and trackable with its finance module that can automate general ledger recording, managing accounts payable & receivable, tracking cash flow, and ensuring complete financial compliance.
Key Takeaways:
- Deferred Income is the advance payment a business has received for the goods or services that it has not delivered yet to the customers.
- Schedule III of the Companies Act, 2013 classifies deferred income as either a current or non-current liability based on the expected fulfilment period.
- The accounting treatment for deferred income is: Credit Deferred Income and Debit Cash on receipt; Debit Deferred Income and Credit Revenue upon delivery.
- Automatically recording deferred income using Sage X3 helps businesses improve financial transparency, perform cash flow planning, and ensure audit-readiness.
Why is Deferred Income Treated as a Liability?
As a business owner, it may sound confusing when cash coming into your company is recorded as a liability.
Think of it this way: Your company has taken cash in advance from customers for something which you have not delivered yet. Thus, you owe goods or services to your customers, and are under a legal obligation to fulfil the order.
If your business fails to deliver those products or services for whatever reason, you will have to issue a refund, which makes it your current liability. But if you deliver them on time, you will turn your current liability into actual revenue (sales/ service income).
Deferred Income Examples Across Different Industries
The concept of deferred income is widely popular across many industries in India, including software industries, travel agencies, educational institutes, and architecture firms. Here are the most common example scenarios:
- Software as a Service (SaaS): Indian software companies receive advance subscription payments from their individual as well as business customers. They are under an obligation to provide the software services (including updates & upgrades as per the End User License Agreement).
- Travel Agencies: Customers make advance payments to travel agencies for various vacation packages. As the company receives payment even before the travel takes place, it is recorded as deferred income rather than revenue.
- Educational Institutes: Educational institutes receive advance payments from their students for various professional courses. Until the services are delivered, they must record the income as deferred income as they are under a contractual obligation.
- Architect Fees: Many Indian architects receive advance payments from their clients for the work which they have not delivered yet. The architect completes the project in the given timeframe and then marks the deferred income as revenue.
What is the Accounting Entry for Deferred Income?
Recording deferred income is a straightforward process. If you’re already using ERP software such as Sage X3 for financial management, here’s the good news: This task is already automated and simplified.
Deferred Income Accounting Process in India
- Upon receiving upfront payment: Debit to Cash/ Bank and credit to Deferred Income (Liability) account
- Upon Delivery: Debit Deferred Income and credit to Revenue/ Sales account.
Balance Sheet Classification
Schedule III of the Companies Act, 2013 classifies deferred income into two categories, namely Current Liabilities and Non-Current Liabilities.
- Current liabilities: These include all those liabilities that have to be fulfilled within 12 months.
- Non-current liabilities: These include long-term liabilities extending beyond 12 months.
Best Practices for Managing Deferred Income
Some of the best practices for managing deferred income are regularly tracking advance payments, automating the task with ERP software, maintaining enough cash reserves, reviewing agreements periodically, and ensuring audit-readiness.
- Track Advance Payments: Keep an eye on advance payments received to minimize accounting errors and ensure accuracy of the books of accounts.
- Use an ERP Software: The finance module in ERP automates record-keeping and adjustments into the journal entries, freeing up your staff for more strategic work.
- Maintain Cash Reserves: Set aside some funds to be used in the event you couldn’t fulfil customer orders.
- Periodic Agreements Review: It’s a good practice to regularly review your agreements and obligations to ensure timely fulfilment and higher accuracy at all levels.
- Ensure Audit-readiness: Closely work with an experienced accountant to prepare your books of accounts for year-end reporting and maintain audit-readiness.
Advantages and Disadvantages of Deferred Income
Now, let’s deep dive into the advantages and disadvantages of deferred income.
Advantages of Deferred Income
- Upfront Cash Flow: Receiving cash in advance for undelivered products or services helps owners fund various business operations and focus on growth strategies.
- Income Predictability: Estimating future income opportunities and planning business activities becomes easier.
- Financial Compliance: Deferred income is turned into revenue only after actual fulfilment, ensuring compliance with basic accounting principles.
- Improved Financial Transparency: Recording deferred income helps reflect a clear and transparent picture of your company’s financial statements.
Disadvantages of Deferred Income
- Cash Flow Risk: If a business spends all of its upfront payments, it risks not having adequate liquid cash to pay bills, fund daily operations, and implement growth strategies.
- Refund Risk: The business is still at risk of returning advance cash received for goods or services it hasn’t delivered yet.
- Intricate Audit Process: Tracking income across multiple contracts increases the complexity of the auditing process.
- Managing Customer Expectations: Typically, when customers make advance payments, they expect superior quality of goods or services.
Deferred Income vs Accrued Income vs Accounts Receivable
Here’s the difference between Deferred Income vs Accrued Income vs Accounts Receivable:
| Deferred Income | Accrued Income | Accounts Receivable | |
|---|---|---|---|
| Meaning | Payment received in advance for goods or services that are yet to be delivered | Income earned by the business but not received yet | Money owed by customers for the goods or services already delivered |
| Example | An educational institute receives an upfront fee from students for various professional courses | A vehicle repair company repairs industrial vehicles in January but issues an invoice in February | A marketing agency delivers work to an international client with payment due in 90 days |
| Balance Sheet Classification | Current Liability | Current Asset | Current Asset |
| Accounting Treatment | Liability during upfront payment; Revenue after order fulfilment | An Asset and corresponding Revenue at the accounting year end | Asset during invoice generation and reduced upon receiving the payment |
| Revenue Recognition | Only after actual order fulfilment | Immediately upon earning, even if payment is still pending | Upon invoice generation |
| Invoice Status | May already be issued | Not yet issued | Already issued |
| Business Obligation | Owes goods or services to customers | Customer owes payment to the business | Customer owes payment to the business |
Automate Deferred Income Accounting with Sage X3
Accurately recording deferred income into the books of accounts can help you keep them transparent and meet regulatory compliance. Moreover, it will give you a clear picture of your future committed earnings, maintain an accurate cash flow, and meet customer expectations.
A modern ERP software such as Sage X3 plays a critical role in tracking, managing, and automating deferred income accounting. It eliminates the hassle of managing hundreds of spreadsheets for different customer contracts, thus freeing up your staff for more strategic operations, eliminating human errors, and preventing potential revenue leakage.
Frequently Asked Questions (FAQs)
1. What is the deferred income meaning in simple words?
Deferred Income is the upfront payment received by a business for the goods or services that are yet to be delivered or fulfilled. In other words, the business has received cash in advance with an obligation to fulfil delivery of goods or services in the future.
2. Is deferred income a DR or CR?
Deferred income is a CR (a Credit entry) because it is treated as a liability. This is because the business has taken early payment for goods or services that have not been delivered yet.
3. How does deferred income affect cash flow?
Since deferred income is an advance payment for goods or services that are yet to be delivered, it creates an immediate cash inflow for the company. In other words, you could have a high cash inflow without income, and vice versa.
4. Is deferred income the same as unearned income?
Yes, deferred income is also called unearned income. Both terms are used interchangeably to describe business liability for the payment received in cash for the goods or services that haven’t been delivered yet.
5. Is deferred income a current asset?
No, deferred income is not a current asset. In contrast, it is a current liability as it indicates advance payment for goods or services that have not been delivered yet.
6. Is deferred income the same as accrued income?
No, deferred income and accrued income are both different terms. Deferred income is the income received in cash before actual fulfilment of goods or services, while accrued income is the income earned by the business but hasn’t been received in cash yet.
