September 09, 2019

What is Unearned Revenue in Accounting?

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What is Unearned Revenue in Accounting?

Revenue is an increase in an enterprise’s economic benefits over a specified reporting period. Revenue may come in the form of a revenue receipt (this is money received through regular business operations), asset sales, or a decrease in liabilities. Revenue leads to an increase in equity; however, contributions from owners (known as participants) do not count towards this.

Revenue can be the result of the supply or production of goods, the provision of services, and other business activities. The definition of revenue covers income from ordinary business activities as well as profits from other sources. These may include an increase in the value of stocks, bonds, investments, foreign exchange gains, etc. Revenue from ordinary activities are incomes generated during a business’s day-to-day operations. These revenues are categorized as: revenue, fees, interest, dividends, and royalties. For some businesses, a part of their revenue is classified as unearned revenue. This article will discuss in detail when that occurs, and how to properly account for such funds, as well as answer a commonly occurring question, “Is unearned revenue a liability?”

What is Unearned Revenue and When Does it Occur?

Unearned revenue comprises funds that a company has received for goods or services that it has not yet provided. Thus, unearned revenue is the amount of money that customers have paid for products or services that will be made available to them in the future. This may be rent paid in advance or other payments received from customers ahead of the products or services being delivered. Some examples:

  • Subscription payments
  • Airline, sports and concert tickets
  • Prepaid insurance
  • Service contracts, etc.

A company must record the cash flow coming in and out of its business. The unearned revenue on the company’s balance sheet is usually treated as a current liability. The business should move relevant portions of unearned revenue to earned revenues during a specific reporting period. Only when the company has fulfilled the entirety of its obligations, and has moved unearned revenues to revenues, can that money be included in the income statement. 

Companies prefer unearned revenues in the form of cash, as they can be sure that the customer is committed to purchasing their goods or services. Thus, when a business records its unearned income, the cash account for assets is debited, and the unearned income account for liabilities is credited. Both accounts increase as a result.

However, there might be cases when the company is unable to deliver the goods or services. In this case, customers receive a refund, and the unearned revenue account decreases.

In most cases, the company can use the money that customers have paid in advance to fulfill their obligations and cover any related expenses. It should be noted that unearned revenue can include a partial payment made to secure an agreement for future goods or services.

Unearned Revenue Benefits

Real estate and insurance companies typically have the most unearned revenue, because they require their clients to pay upfront. Only after making the payment do clients gain access to the property or receive the necessary insurance. The benefit of receiving unearned revenue is a significant cash income that can be used to provide the promised services and goods. This means that the company does not need to have considerable upfront capital.

Unearned revenues help company’s owners or board members more easily determine its financial health for the immediate future. Additionally, companies with unearned revenue accounts can also show potential investors how much revenue they expect to earn in the upcoming period. Substantial unearned revenues demonstrate that customers trust the company, which further increases its value.

It is important to properly document unearned revenues in order to accurately evaluate the financial stability of an enterprise. It is also imperative when seeking investor capital or other forms of business financing. 

What Types of Companies Have Unearned Revenue?

What is Unearned Revenue in Accounting?

Most companies that accept or require payments in advance have unearned revenues. Such companies must provide the agreed-upon services or goods, and if they fail to do so, must issue a refund or a credit. Any business should know how to keep a record of unearned revenues. However, there are businesses for whom unearned revenue naturally forms a large part of their transaction records, and for those types of companies, it is all the more important to properly account for any unearned revenues in their ledgers. Here’s a look at some of these businesses:

Subscription-Based Companies

Magazine and newspaper publishing companies are a great example of an industry that has a relatively large cash flow in unearned revenues. The subscription-based sector is not limited to publishers. It also includes companies that provide software on a subscription basis, as well as fitness centers, food delivery services, etc. In short, any business that collects a monthly or annual subscription fee falls into this category.

Ticket Sellers

Any company that sells tickets to an upcoming sporting event or a concert needs to record the payments as unearned revenue, and only after the event is over can  they transfer the relevant funds into the revenues account. Airlines also belong to this category. 

Prepaid services

Most of us use prepaid services in our daily lives.  Maintenance services, lawn care, and household cleaning are the most popular. The customer either pays for the service in advance with a product purchase, or signs a contract for service to be provided over a period of time. The customer will then pay the full amount only upon successful delivery of the product or the completion of the service period. The company providing products or services on a prepaid basis will record the cash flow from the payment as unearned revenue until the completion of the agreement and receipt of the full payment.

Online Retailers

Online retailers such as Amazon or Etsy sellers take payments upfront. Only upon receiving payment do they physically ship their goods. Collecting payments upfront minimizes the risk for the business. Being able to collect fees upfront is especially valuable for sellers who manufacture custom products. Whether the business asks for a pre-payment in full or a down payment, the money that is received by the business upfront needs to be recorded as unearned revenue. 

Unearned Revenue Examples

Is unearned revenue a liability? Unearned (deferred) income is attributed to the company’s liability accounts for the duration of the deferral. For example, publishers usually receive a payment for a magazine subscription in advance. This payment will be recorded on the liabilities account. If the publisher does not deliver the magazines that its customers have already paid for, readers will expect a refund. As each issue of the magazine is delivered, the publisher earns a portion of the funds received in advance. This portion must be transferred from the “Unearned Subscription” to the “Subscription Revenue” account. Specifically, the amounts are transferred from the liabilities to the assets side of the balance sheet. Let’s review another example of unearned revenue and see how a company would record it. On February 1, the example company received a $13,500 payment from a customer for maintenance services to be provided over the next two months. The entry to record the receipt of cash would look like this:

What is Unearned Revenue in Accounting?
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