Unearned revenue is also known as deferred revenue or deferred income. It is a prepayment received by an individual supplier or a company from a customer who ordered the delivery of goods or services at a later date. Any company or individual supplier who has received an unearned revenue has a liability equal to that “prepayment” until the goods or services are delivered. Since it is not yet earned, this revenue is like a debt owed to customers. Companies or individual suppliers with unearned revenue usually record it in their balance sheets as a liability. Once they deliver the goods or services to customers, unearned revenue becomes revenue to the company or the individual supplier. It is recorded in the income statement on the gains side.
Examples of Unearned Revenue
This type of revenue is common among individual suppliers and companies dealing with subscription-based products or other services that require prepayments. Some examples include an advanced rental payment, airline tickets, legal retailer, prepaid insurance, newspaper or publishing subscriptions, contract services, and annual prepayment for the use of software license.
Collection of Unearned Revenue
Collecting unearned revenue from your customers is also a task on its own. Specialized cloud-based accounting and invoicing software such as Fresh-Books is needed to provide a trusted and long-lasting solution. This technique offers three different options through which one can collect this unearned revenue from customers. These include:
- Through deposits where you can request your customer to make a deposit when you are creating a new invoice. These deposits can either be expressed as a flat fee or a percentage of the invoice.
- Through advanced payments like in, for example, services or goods which entails subscriptions and other recurring invoices. A company can automatically store customer’s credit card information so that you can bill them when you need to.
- Through retainers, whereby a company can bill customers a fixed amount up front and then track time towards their retainer. If you clocked more hours than the retainer covered, you could easily bill for that excess time on a one-off invoice.
Accounting for Unearned Revenue
According to accounting’s accrual concept, unearned revenues are considered liabilities. It is to be noted that under the accrual concept, income is recognized when earned, regardless of when collected. Since the products or the services are yet to be delivered, companies in possession of the unearned revenue should treat it as a debt they owe the clients, thus recording it in their balance sheets as a liability. Usually, unearned income is recorded as a short-term or current liability, but depending on the repayment terms, it can also be a long term liability. For instance, when a client makes an advanced payment for products or services the company needs to deliver in less than 12 months, then it becomes a current liability. However, when the obligation cannot be fulfilled within 12 months, then the respective unearned revenue can be recognized as long term liability.
As the company is delivering the services or the product over time gradually, then the prepaid amount is being earned by the company, and it is recognized as revenue on the company’s income statement. Assuming that XYZ Limited, a publishing company, accepts $24,000 for a six-month subscription, an accountant records the amount as an increase in cash and an increase in unearned revenue. In each case, the figure appears in the balance sheet accounts meaning income statements are not affected immediately. So if the publications are to be delivered monthly, every time each monthly portion is delivered, the current liability (unearned revenue) is reduced by $4,000 ($24,000 divided by six months). Revenue increases by the same amount.
If a company has not correctly handled unearned revenue as stated above and happens to recover it all at once and not periodically as earlier expected, then the revenue and profits would be overstated. It is then understated for the additional periods during which the revenue and profits should have been recognized. In accounting terms, we say that the matching principle has been violated as the revenue is recognized once while the related expenses are not being recognized until the last periods.
Unearned Revenue Reporting Requirements
Unearned revenue is treated differently across the globe. For instance, in the United States, under the Securities and Exchange Commission, a public company must meet specific criteria for the revenue to be recognized as such. This criterion includes shifting delivery ownership, collection probability — a reasonable estimate of an amount for doubtful accounts — and evidence of an arrangement plus the determined price. If these criteria are not met, then revenue recognition is deferred.
Benefits of Unearned Revenue
Unearned revenue is very beneficial to many companies and suppliers because of several reasons. Below are three main ways a small business can benefit from unearned income, despite it being a liability.
Gets money in your pocket, sooner
Payment for goods already delivered has always been a problem, and most businesses have always lost on such transactions. A study by Freelancer’s Union revealed that about 71% of freelancers faced the trouble of not receiving their pay at some point in their careers. Since they say ‘Cash is King’ and you need it to survive, getting money in your pocket sooner will behoove you as you will be able to keep your cash flow positive. This will allow you to stay afloat.
Increases your working capital
Unearned revenue presents itself to a small business as an opportunity to boost the amount of working capital for rounding up its portfolios. Through this, small businesses can cover their day-to-day operations without going for a loan.
Enables your clients to break up payments
Upfront payment is advantageous to the customer, too. For example, it will allow them to break up their project payments into smaller installments. Also, it can attract a discount. Say, for example, you can have an agreement with your supplier that if you pay for the services a year ahead, a certain percentage of discount will be given.
When dealing with unearned revenue, be mindful that this is not the same as buying on credit. It is not the consumer who needs to fulfill a promise, but rather the producer. Once the producer delivers their half of the deal, so to speak, unearned revenue becomes revenue.