What is unearned revenue?  

Unearned revenue, also known as advance payments, refers to a company receiving payment from a customer for goods or services that still need to be provided. It represents an obligation for the company to deliver the product or service at a future date.  

When a customer makes a payment in advance, the company records the amount as a liability on its balance sheet under the category of unearned revenue. The company still needs to earn revenue by fulfilling its part of the transaction. As the company fulfills its obligation and delivers the goods or services, it gradually recognizes the revenue as it is earned and reduces the unearned revenue liability.  

Unearned revenue is common in subscription-based businesses, software companies, airlines, and hospitality industries. For example, if a customer pays for a year-long subscription to a magazine, the magazine company would initially record the payment as unearned revenue and recognize it as revenue gradually over the subscription period as each issue is delivered.  

Unearned revenue is important for accurate financial reporting, as it helps in matching revenue recognition with the related expenses and ensures that financial statements reflect the timing of the company’s performance and delivery of goods or services to customers.  

How can one record unearned revenue?  

Unearned revenue, also known as deferred revenue or prepaid revenue, refers to the money received by a company for goods or services that have yet to be delivered or earned. It represents an obligation to provide the products or services in the future. To record unearned revenue in the accounting books, you can follow these steps:  

– Identify the transaction: Determine the specific goods or services you have received payment for in advance. 

– Create a liability account: Unearned revenue is recorded as a liability because you have a future obligation to deliver the products or services. Create a new liability account in your chart of accounts, typically named “Unearned Revenue” or “Deferred Revenue” .

– Debit the cash or accounts receivable account: Increase the cash account if you received cash or the accounts receivable account if you received payment on credit. This recognizes the receipt of funds. 

– Credit the unearned revenue account: Record an equal amount as a credit to the unearned revenue account. This shows the liability created due to the advance payment. 

– Adjust overtime: As you deliver the goods or services and fulfill your obligation, you must recognize the revenue and reduce the unearned revenue balance. This is typically done by debiting the unearned revenue account and crediting a revenue account, such as “Sales Revenue” or a specific revenue account related to the goods or services provided.

– Recognize revenue: At the point of delivery or completion of the goods or services, you need to recognize revenue by transferring the appropriate amount from the unearned revenue account to a revenue account. 

– Reflect on financial statements: Prepare your financial statements, such as the income and balance sheets, by including the appropriate amounts from the unearned revenue and revenue accounts. The unearned revenue balance represents a liability on the balance sheet until it is earned and recognized as revenue. 

It’s essential to consult with an accounting professional or refer to accounting guidelines specific to your jurisdiction to ensure proper recording of unearned revenue. Accounting practices vary based on industry, regulations, and local accounting standards.  

What are the reporting requirements for unearned revenue?  

Unearned or deferred revenue or advance payments refer to the money a company receives from customers before it has earned it. Reporting requirements for unearned revenue vary depending on the accounting standards followed by the company. Generally Accepted Accounting Principles (GAAP) and International Financial Reporting Standards (IFRS) are the most used standards.   

Under GAAP and IFRS, unearned revenue is initially recorded as a liability on the company’s balance sheet. When the revenue is earned, it is recognized as revenue on the income statement, and the liability is reduced. The specific reporting requirements can be summarized as follows:  

Balance Sheet Presentation

Unearned revenue should be reported as a current liability on the balance sheet until it is recognized as revenue. It should be disclosed separately from other liabilities.  

Disclosure

The company should provide appropriate disclosure in the notes to the financial statements regarding the nature and amount of unearned revenue. This includes details such as the types of goods or services for which the revenue was received in advance and the expected delivery timing.    

Revenue Recognition

When the company has fulfilled its obligations and earned the revenue, it should be recognized as revenue on the income statement. The amount recognized should be equal to the portion of the unearned revenue that has been earned during the reporting period.  

Timing of Recognition

The timing of recognizing unearned revenue as revenue depends on the specific circumstances of the transaction. It is generally recognized when the company transfers control of the goods or services to the customer, who can benefit from them.  

Measurement

Unearned revenue is initially measured at the amount received from the customer. If the consideration received exceeds the fair value of the goods or services provided, the excess should be recognized as a liability or deferred income.  

It’s important to note that specific reporting requirements may differ based on the industry and the unique circumstances of each transaction. It’s recommended to consult with a qualified accountant or refer to the applicable accounting standards for detailed guidance on reporting unearned revenue in a particular jurisdiction.  

What are the benefits of unearned revenue?  

Unearned revenue, also known as deferred revenue or advance payments, refers to the money a company receives from customers before it has delivered the associated goods or services. While unearned revenue is a liability on a company’s balance sheet, there are several benefits associated with it:  

Cash flow

Unearned revenue provides an immediate cash inflow for a company. This can be particularly beneficial for startups or businesses with limited working capital, as it allows them to cover operational expenses or invest in growth initiatives.  

Financial stability

Unearned revenue represents a liability owed to customers, which creates a sense of financial stability for a company. It indicates a confirmed customer base and future business, assuring investors, lenders, and stakeholders.  

Improved planning and budgeting

Companies can better plan their resources and allocate funds accordingly by receiving payments in advance. This can help with budgeting, forecasting, and managing cash flow more effectively, as there is greater visibility into future revenue streams.  

Customer commitment

Customers are more likely to remain committed to the transaction when they pay in advance. They are invested in receiving the goods or services they have already paid for, reducing the likelihood of cancellations or refunds. This can provide greater stability in customer relationships and reduce revenue volatility.  

Reduced credit risk

Unearned revenue reduces credit risk for a company. Since the money has already been received, there is no need to rely on credit sales or worry about collecting payments in the future. This lowers the risk of bad debts and improves the company’s overall financial health.  

Expansion opportunities

Unearned revenue can provide a financial cushion for a company to explore growth opportunities. With the cash received in advance, a company may have the resources to invest in research and development, expand production capacity, or enter new markets, fostering business growth.  

It’s important to note that while unearned revenue offers these benefits, companies must also be mindful of their obligations to deliver the promised goods or services promptly. Proper accounting practices and accurate financial reporting are crucial to managing unearned revenue effectively and ensuring compliance with relevant regulations.  

See Also: Balance Sheet Vs. Income Statement: What’s the Difference?

Endnote

In conclusion, unearned revenue refers to the income a company receives before delivering goods or services to the customer. It represents a liability on the company’s balance sheet as the obligation to fulfill the promised goods or services still exists. Unearned revenue is initially recorded as a liability and then recognized as revenue when the goods or services are provided. The process of recording and reporting unearned revenue involves a few key steps. Firstly, the company debits the cash account and credits the unearned revenue account when the payment is received. This reflects the increase in cash and the corresponding increase in liability.

Farwah Jafri

Farwah Jafri is a financial management expert and Product Owner at Monily, where she leads financial services for small and medium businesses. With over a decade of experience, including a directorial role at Arthur Lawrence UK Ltd., she specializes in bookkeeping, payroll, and financial analytics. Farwah holds an MBA from Alliance Manchester Business School and a BS in Computer Software Engineering. Based in Houston, Texas, she is dedicated to helping businesses better their financial operations.