Audit Procedure for Deferred Revenue

What is Deferred Revenue?

Deferred revenue is a financial concept that plays a crucial role in a company’s accounting practices. It appears as a liability on the company’s balance sheet and is indicative of a prepayment made by customers for goods or services that are yet to be provided. Essentially, it represents an obligation for the company to deliver on its promises.

The recognition of deferred revenue takes place in accordance with Generally Accepted Accounting Principles (GAAP). It adheres to the principles of accounting conservatism, emphasizing prudence and caution in financial reporting. The principle of conservatism ensures that companies do not overstate their financial position or performance, promoting a more realistic and reliable representation of their economic activities.

As per the accounting guidelines, deferred revenue is not immediately recognized as revenue on the income statement. Instead, it is acknowledged as earned revenue only when the corresponding goods or services are delivered to the customer. This careful approach ensures that revenue is recorded only when it is earned and not prematurely, aligning with the fundamental concept of revenue recognition.

The deferred revenue account serves as a mechanism to track these prepayments until the point of delivery. It acts as a liability, reflecting the company’s obligation to fulfill its commitments. The moment the company fulfills its part of the agreement and delivers the promised goods or services, the deferred revenue is then transferred from the balance sheet to the income statement as earned revenue.

Accounting for Deferred Revenue

Deferred revenue, also known as unearned revenue, refers to advance payments a company receives for goods or services that are to be delivered or performed in the future. The company that receives the prepayment records the amount as a liability on its balance sheet. This is because the company has not yet earned the revenue and therefore owes the customer the goods or services.

Here’s a breakdown of accounting for deferred revenue:

1. Initial Recording:

When a company receives a prepayment, it records the amount as a debit to the cash account and a credit to the deferred revenue account. This increases the company’s cash balance and creates a liability for the undelivered goods or services.

Journal Entry:

2. Recognizing Revenue as Earned:

As the company delivers the goods or services, it recognizes a portion of the deferred revenue as earned revenue. This is done by debiting the deferred revenue account and crediting the revenue account. The amount of revenue recognized depends on the specific terms of the agreement with the customer.

Journal Entry:

3. Refunding Unearned Revenue:

If a customer cancels their subscription or the company is unable to deliver the goods or services, it must refund the unearned portion of the deferred revenue. This is done by debiting the deferred revenue account and crediting the cash account.

Journal Entry:

Here’s a table summarizing the journal entries for deferred revenue:

Audit Risk

• There is a risk that the company may not have appropriately recognized or measured deferred revenue. This could occur if the criteria for recognizing deferred revenue are not applied correctly or if there are errors in measuring the amount of revenue to be deferred.
• The timing of recognizing deferred revenue is critical. Auditors must ensure that revenue is recognized only when the goods or services are delivered as per the contractual terms.
• Deferred revenue often involves estimating future performance obligations. There is a risk that the company’s estimates regarding the completion of services or delivery of goods may be inaccurate.
• Inaccurate recognition: Revenue might be recognized prematurely before goods or services are delivered, inflating current period income. This can be caused by aggressive revenue recognition policies, lack of clear performance obligations, or inadequate controls over the timing of revenue recognition.
• Fictitious contracts: Fake contracts or invoices may be created to inflate deferred revenue and manipulate financial statements.
• Inadequate recognition: Revenue might be incorrectly classified as deferred when it should be recognized immediately, leading to understated current period income. This can happen due to misinterpretation of performance obligations or poor understanding of accounting standards.
• Non-recognition of refunds: Customer refunds or cancellations might not be accurately reflected in the deferred revenue account, leading to overstated liabilities.

Internal Control

Establishing effective internal controls is crucial for managing deferred revenue accurately and ensuring compliance with accounting standards. Internal controls help safeguard against errors, fraud, and mismanagement. Here are key internal controls relevant to deferred revenue:

• Contract Review and Approval: Implement a process for thorough contract review and approval before accepting prepayments. This involves ensuring that contractual terms are clear, obligations are well-defined, and revenue recognition criteria are met.
• Segregation of Duties: Separate the duties related to processing customer payments, recording transactions, and authorizing revenue recognition. Segregating these duties helps prevent collusion and enhances the reliability of financial reporting.
• Documentation of Contracts: Establish a system for comprehensive documentation of customer contracts. This documentation should include terms, conditions, performance obligations, and any contingencies associated with deferred revenue.
• Performance Obligation Assessment: Develop a process to assess and document the satisfaction of performance obligations before recognizing deferred revenue as earned. This ensures that revenue is only recognized when the company has fulfilled its commitments.
• System Controls and Automation: Implement controls within accounting systems to automate deferred revenue recognition based on predefined criteria. This helps reduce manual errors and ensures consistency in the application of revenue recognition policies.
• Regular Reconciliation: Establish a periodic reconciliation process to compare the balances in the deferred revenue account with supporting documentation, such as customer contracts and delivery records. This helps identify discrepancies and ensures accuracy.
• Monitoring of Refund Obligations: Develop a process for monitoring and managing refund obligations associated with deferred revenue. This includes assessing whether performance obligations can be met and determining when refunds are necessary.
• Management Oversight and Review: Implement a review process where management periodically assesses the status of deferred revenue, ensuring compliance with accounting policies and the accuracy of financial reporting.
• Employee Training: Provide training to employees involved in the deferred revenue process to ensure they understand the company’s policies, GAAP requirements, and the importance of accurate and timely recording of deferred revenue.
• Audit Trails and Documentation: Maintain detailed audit trails and documentation supporting deferred revenue transactions. This documentation should be readily available for internal and external auditors, facilitating the audit process.

Audit Assertion

1. Existence: Deferred revenue represents valid prepayments from customers and exists as a legitimate financial obligation.
2. Completeness: All relevant deferred revenue transactions and balances have been accurately recorded in the financial statements.
3. Rights and Obligations: The company has the legal right to deferred revenue, and there is a corresponding obligation to deliver goods or services in the future.
4. Valuation or Allocation: Deferred revenue is accurately measured, and the allocation to different periods is consistent with the timing of performance obligations.
5. Accuracy: The recorded amounts of deferred revenue are precise and free from material errors or misstatements.
6. Classification: Deferred revenue is appropriately classified as a liability on the balance sheet, clearly distinguishing it from other financial statement items.
7. Presentation and Disclosure: Deferred revenue is presented and disclosed in the financial statements under applicable accounting standards, providing relevant details about the nature and timing of performance obligations.
8. Cut-off: Deferred revenue is recorded in the correct accounting period, reflecting the timing of the customer payments and the fulfillment of performance obligations.

Audit Procedure

• Review contracts and agreements: Examine a sample of contracts to verify the terms of payment, performance obligations, and revenue recognition criteria.
• Test revenue recognition: Perform calculations to ensure revenue is recognized in the correct period and in accordance with applicable accounting standards.
• Reconcile deferred revenue balances: Compare deferred revenue balances to supporting documentation, such as contracts, invoices, and delivery records.
• Test cutoff: Verify that revenue and expenses are recorded in the correct period, especially around year-end.
• Review subsequent events: Assess any events after the balance sheet date that might affect deferred revenue balances, such as cancellations or refunds.