Deferred Revenue Expenditure: An In-depth Analysis

Deferred Revenue Expenditures are those costs that are not entirely consumed in the period they are paid for but are not significant enough to be capitalized as assets. Instead, they are written off over a predetermined number of years, allowing the company to match the expense recognition with the periods in which the benefits of the expenditure are realized. Examples might include extensive advertising campaigns, research and development costs, or the preliminary expenses of a startup.

Deferred revenue expenditure is the cost incurred in the current accounting period but its advantages are realized in future accounting periods. This expense may be deducted over a number of years or in the same fiscal year.

Table of Contents

• What is Deferred Revenue Expenditure?
• Examples
• Classification of Deferred Revenue Expenditure
• Adjustments
• Features
• Capital Expenditure vs Deferred Revenue Expenditure

What is Deferred Revenue Expenditure?

Let us consider an instance to understand this expenditure. Startups often invest heavily in marketing and advertising during their initial phases to establish a market presence. While the expense is incurred upfront, the benefits, in terms of customer acquisition and brand recognition, are realized over multiple years, aligning with the Matching principle of accounting.

• Imagine you buy a sapling (a young tree) for your garden.
• This sapling costs you $100. Instead of thinking of the entire $100 as an expense for this year, you consider that this tree will grow, bear fruit, and provide shade for many years to come.
• So, you decide to spread out the $100 cost over the expected life of the tree, say 10 years.
• This means you only account for $10 of the cost this year, and you’ll do the same for the next nine years.

In this analogy:

• The $100 you spent on the sapling represents the deferred revenue expenditure.
• The 10 years over which you spread the cost is the period over which you expect to benefit from the expenditure.
• The $10 you account for each year is similar to writing off a portion of the deferred revenue expenditure annually.

Just like you wouldn’t consider the entire cost of the sapling in the year you bought it (because it will benefit you for many years), businesses don’t account for certain expenditures all at once if they expect to benefit from them over a longer period. Instead, they spread out the cost over several years.

Examples

1. Prepaid Expenses

Companies might invest significantly in sales promotion activities. For instance, a company launching a new product might pay for a year-long billboard advertisement. Even though the payment is made upfront, the advertisement will be visible and beneficial for the entire year. This Prepaid Expense is recognized in the balance sheet and is gradually expensed in the income statement over the year as the company benefits from the advertisement each month.

2. Exceptional Losses

Expenditures related to unforeseen events can have long-lasting financial impacts. For example, a business might suffer damages due to a major earthquake. While the immediate repair costs are significant, the business might decide to spread these costs over several years, especially if they believe the earthquake has also impacted their brand image or customer trust, and recovery will take time.

3. Services Rendered

Costs associated with services that benefit the company over multiple years can be significant. Consider a company investing in a specialized training program for its employees. This training might be expensive initially, but the skills and efficiencies gained from it will benefit the company for several years. The company would recognize the cost of this training as a deferred revenue expenditure, writing it off over the years as employees apply their new skills.

4. Fictitious Assets

Fictitious assets are not tangible assets but still provide benefits over an extended period. For instance, a company might pay a premium to obtain a prime-time slot for a TV advertisement. The slot itself is not a tangible asset, but the premium viewership time can lead to increased sales and brand recognition over several years. The company would spread the cost of this premium slot over the years, and it expects to see increased sales.

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Classification of Deferred Revenue Expenditure

Here is a breakdown of different types of deferred revenue expenditures:

1. Based on the nature of the expense

• Prepaid Insurance: Premiums paid in advance for insurance coverage beyond the current accounting period.
• Prepaid Rent: Rent paid in advance for future occupancy of a property.
• Prepaid Subscriptions: Subscriptions to services or publications paid for before the period of use begins.
• Deposits and advances: Payments made in advance for goods or services to be received in the future.
• Promotional or advertising costs: Expenditure made for campaigns or events that will benefit future periods.

2. Based on the length of the deferral period

• Short-term: Expenses expected to be used within the next year, typically shown as a current asset in the balance sheet. Examples include prepaid rent for a few months or insurance premiums for a quarter.
• Long-term: Expenses not expected to be used within the next year, and therefore classified as non-current assets on the balance sheet. Examples include advance payments for multi-year subscriptions or long-term lease deposits.

3. Based on the recognition method

• Straight-line method: The cost of the deferred expenditure is allocated equally to each accounting period over its useful life.
• Amortization method: The cost of the deferred expenditure is allocated based on the expected pattern of benefits it will provide.

Adjustment of Deferred Revenue Expenditure

Let us now understand the adjustment of this type of expenditure in final accounts. It is an investment whose advantages extend beyond one accounting period. It signifies that an expense that has been incurred in one instance, yields benefits that unfold over subsequent years. If the entire expense were recorded in the current year, it could result in an understated business profit and an inaccurate depiction of the financial status in the balance sheet. Hence, this expenditure is distributed across multiple years based on the anticipated benefits expected to materialize annually.

A. Deferred Revenue Expenditure is provided outside the trial balance:

• It will be recorded as an expense on Debit side of Profit & Loss Account. 
• The remaining balance will be listed as asset on assets side of Balance Sheet.

B. Deferred Revenue Expenditure is included within the trial balance: 

Only the remaining balance will be displayed as asset on assets side of balance sheet. Suppose, the trial balance of a person is:

• Out of the total promotional expenditure incurred, ₹5,000 belongs to the current year.
• Goods used for business amount to ₹20,000.
• Goods sent to customers on sale or return basis at cost worth ₹10,000 plus 15% profit.
• Goods in transit is costing ₹2,000.
• A manager gets a commission @10% on net profit before charging any commission.
• Closing stock is ₹7,500.

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Features of Deferred Revenue Expenditure

• The expenditure is essentially revenue expenditure in nature.
• Benefits from the expenditure span more than one accounting year.
• It represents a significant one-time investing for the business.
• The benefits accrue over future years, either partially or entirely.
• It’s crucial to disclose such expenditures in the income statement and balance sheet for transparency.

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Capital Expenditure vs Deferred Revenue Expenditure

• Duration of Benefits: Capital Expenditure (CAPEX) benefits a business for a longer duration, often ten years or more, making it a long-term asset. In contrast, the benefits from deferred revenue expenditure are typically realized between 3 to 5 years.
• Nature of Expenditure: CAPEX is associated with investments that increase a business’s earning capacity, such as purchasing machinery or copyrights. Deferred revenue expenditure, on the other hand, maintains the earning capacity of the business, like investments in advertising.
• Conversion to Cash: Capital expenditures can often be converted to cash since they create tangible assets. Deferred revenue expenditures, mainly incurred on sales promotion and advertising, cannot be easily converted to cash.
• Write-off Period: CAPEX is written off using depreciation over its useful life. Deferred revenue expenditure is typically written off over 3 to 5 years from the year it was incurred. The unamortized cost represents the portion not yet written off, while the Unexpired Cost pertains to the cost that hasn’t been utilized.
• Liabilities and Assets: While deferred revenue expenditure can be considered a long-term asset when not written off entirely, it doesn’t represent a long-term liability as there is no future payment obligation.

Conclusion

Deferred revenue expenditure is an important concept in accounting. It ensures that expenses align with the periods they benefit while adhering to Revenue Recognition principle. By understanding deferred revenue expenditures, businesses can achieve more accurate financial reporting and make informed decisions accordingly.