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The Simple Difference between Earned vs. Deferred (Unearned) Revenue.

Peter A. Sangiorgio is the former CFO of Metropolis Magazine. He holds a B.S. in Accounting
and an M.B.A in Controllership from St. John’s University. He is a member of the
Institute of Management Accountants (IMA) and is currently pursuing a Certified Management Accountant (CMA) credential.  Contact Peter at pacs@erols.com

Before I attempt to outline the difference between Earned vs. Deferred Revenue as it relates to Subscriptions, it is important to define a few related terms.  To conform to Generally Accepted Accounting Principles (GAAP), all expenses and revenues must be recorded on the accounting books during the period in which the activity occurs. This is called the matching principle. Expenses must be recorded when the expense was incurred and revenues must be recorded during the period in which they are earned. Because of this principle, organizations adjust entries to their accounting books. Magazine publishers’ accounting practices are geared to the timing of the recognition of subscription revenue. Per GAAP, revenues on the income statement must be recorded on an accrual basis. Accrual accounting is the practice of the matching principle (accounting for revenues in the period in which they are earned and expenses in the period in which they are incurred). Accrual accounting contrasts with Cash Basis Accounting, in which revenue is recorded when cash is received by customers and expenses recorded when they are paid in cash. 

Deferred Subscription Revenue

The word “deferred” refers to postponing an event. Deferred Subscription Revenue occurs when cash is received by a customer for revenue that the company has not yet “earned”. Subscription revenue paid in advance is considered “Deferred” or Unearned until the subscription copies are delivered. It is classified as a liability on the balance sheet. If a subscriber pays you for an annual subscription, you are responsible for providing that subscriber with the subscription for one year. So, what would happen if you failed to provide this subscription for the entire term agreed? You would then owe the subscriber a refund.  It is because of this concept that the amount “owed” is considered a liability. You can record the sale without a prepayment and involve a subscription account receivable by billing the customer, but for the purposes of this explanation we will assume that a prepayment has been made. Sales made on credit, accounts receivable entries, and allowances for returns are all topics for another day.

Deferred entries allow companies to abide by the matching principle. It involves making adjusting entries to their accounting books and affects the balance sheet and the income statement. The balance sheet is a statement of financial position of an organization as of a specific period in time or as of a certain date. Let’s say …As of Dec 31, 2012. The income statement is a profit & loss statement, which reveals how an organization performed with respect to revenues and related expenses over a period of time. Let’s say… For the Period Ending Dec 31, 2012.  

There are many ways to keep track of what is considered deferred and when to adjust prior deferred revenue to earned revenue. Accrual accounting, which incorporates the matching principle, presents a special challenge for accountants because the actual payment and actual delivery may fall in different accounting periods. A publisher can maintain their own schedules to properly recognize the sold subscription over the life of the subscription or they can employ fulfillment service companies to do this for them. Fulfillment companies are extremely well equipped to handle this task for the publisher and provide the publisher with extensive and detailed period reports that make it easier for the publisher to do.

The following represents a simplified example of an annual magazine subscription at the initial transaction:

XYZ Publishing Co. publishes their publication 12 times per year. Their annual subscription sells for $72 per year. Each monthly issue sells for $6.

Initial journal entry at time of Sale of annual Subscription (if full amount of cash is prepaid)
                                                       Debit                           Credit
Cash                                                $72                                             (Asset on Balance Sheet)
Deferred Sub Revenue                                                         $72         (Liability on Balance Sheet)

Earned Subscription Revenue

The first part of the transaction when a magazine subscription is sold is to set up the Deferral as a liability as demonstrated in the above example. As stated previously, the publisher cannot recognize the full sale price of the subscription until it mails all of the magazines related to the annual subscription. Earned revenue relates to the completion of this transaction. Every time the publisher delivers 1 issue, the company records a portion (1/12th) of the entire sale as Earned Revenue. It reduces that portion of the liability by debiting the Deferred Sub Revenue account, and records that portion as Income by crediting the Earned Revenue account.

Adjusting journal entry as each monthly issue copy is delivered to customer

                                                      Debit                           Credit
Deferred Sub Revenue                        $6                                             (Liability on Balance Sheet)
Earned Sub Revenue                                                             $6           (Income item on P&L)

 

The adjusting entry above which recognizes that monthly portion of Earned Revenue is repeated until all copies are delivered to the customer and the balance in the liability account (Deferred Subscription Revenue) is zero. In reality, these balances that are shown on the publishers’ financial statements are summarized and not shown by individual customer. So the total liability account (Deferred Subscription Revenue) is always shown as an aggregate number of all customer subscriptions and is updated on a rolling basis.

Understanding the difference between Earned vs. Deferred Subscription Revenue is extremely important and necessary because of its adherence to Generally Accepted Accounting Principles. GAAP is the collection of many rules on how to account for various transactions. By using consistent principles, all companies reporting under GAAP report these transactions on their financial statements in a consistent and fair manner. In the discussion above, if GAAP is not adhered to properly, it can affect how accurately the company reports its income by misstating their revenue in specific reporting periods. People rely on financial statements to be accurate and conforming to GAAP and thus make critical decisions based upon this information. So, in conclusion, publishers should always consult with a professional accountant who has extensive knowledge of GAAP and specifically the rules for revenue recognition. They should also have a good fulfillment reporting system or use a respected fulfillment service company that can assist you in satisfying your reporting duties.