Most business owners would agree: properly accounting for unearned revenue can be confusing.
But with the right understanding of what unearned revenue is, you can accurately record it and convert more of it into earned revenue over time.
In this post, you'll get a complete overview of unearned revenue, from its definition to examples and journal entries. You'll also learn key strategies for managing unearned revenue to improve your financial health.
Introduction to Unearned Revenue
Unearned revenue, also known as deferred revenue, refers to money received by a business from a customer for products or services that have not yet been delivered or performed. It appears as a liability on a company's balance sheet because there is still a future obligation to the customer after the payment has been made. Monitoring unearned revenue is important for accurate financial reporting.
Defining Unearned Revenue in Accounting
Unearned revenue is recorded when a company receives payment but has not yet fulfilled its side of the agreement by transferring goods or providing services. For example, if a customer pays for a 1-year magazine subscription upfront, the publisher will note this as unearned revenue until each magazine is delivered over the next 12 months. The unearned amount is recognized gradually as revenue on the income statement during the subscription period.
Some common examples that generate unearned revenue for businesses include:
- Annual subscriptions - Payment is made upfront for content or access over a 12-month period
- Prepaid rentals - A rental fee is paid in advance of utilizing equipment or space
- Gift card sales - Customers prepay for future purchases at the retail value of the card
- Deposits - Partially paying for a larger product or service before fulfillment
In each case, goods have not transferred or services have not been fully rendered, so a liability represents the value still owed to the customer after payment.
The Importance of Tracking Unearned Revenue
Monitoring unearned revenue as a distinct line item is crucial for accurate financial statements. It:
- Prevents overreporting revenue and profits not yet earned
- Shows the portion of future revenue already collected in advance
- Allows matching of revenue with related expenses as they are incurred
- Tracks progress delivering on customer contracts and payments
Reviewing unearned revenue assists in cash flow planning and projecting future earnings. It also provides insight into business performance - unusually high accounts may signal issues meeting obligations. Careful accounting for unearned amounts leads to realistic financial reporting.
What is an example of unearned revenue?
A few typical examples of unearned revenue include airline tickets, prepaid insurance, advance rent payments, or annual subscriptions for media or software. For example, imagine that a customer purchases an annual subscription for a streaming music service. The customer pays $50 up front for the full year of service.
When the customer pays the $50 upfront, the company receiving the money records this payment as a liability, not as revenue. This is because the $50 covers the full year of service that has not yet been delivered to the customer. So at the beginning, this $50 is considered "unearned revenue" - it is revenue that has not yet been earned by providing the service.
As each month goes by, the company delivers the streaming service to the customer. At the end of each month, the company reduces the unearned revenue amount and records that portion as revenue on its income statement. This process continues each month until the end of the 12 month subscription period when the full $50 payment has been fully earned as streaming service revenue.
Some key things to note about unearned revenue:
- It is recorded as a liability on the balance sheet because the business has an obligation to deliver goods or services in the future.
- As goods/services are delivered over time, unearned revenue is reduced and earned revenue is increased.
- Common examples are subscriptions, gift cards, annual maintenance contracts or any business that receives payments upfront but delivers over time.
So in summary, unearned revenue represents cash received for goods or services that have not yet been delivered or earned by the business. It is a liability until the business satisfies its obligations and records the amounts as earned revenue.
Where is unearned revenue on balance sheet?
Unearned revenue is listed under “current liabilities” on the balance sheet. It is part of the total current liabilities as well as total liabilities.
On a balance sheet, assets must always equal equity plus liabilities. So unearned revenue, as a liability, is on the opposite side of assets.
When a business receives payment in advance for products or services not yet delivered, it must record this payment as a liability, specifically as unearned revenue. As the products/services are eventually delivered over time, portions of the unearned revenue balance are reduced and recognized as earned revenue on the income statement.
The unearned revenue account reflects the obligation the company has to its customers for payments received in advance. Tracking unearned revenue is important for accurate financial reporting.
What is unearned revenue identified as?
Unearned revenue, also known as deferred revenue, is recorded as a liability on a company's balance sheet. It represents payment received in advance for products or services that have not yet been delivered or performed.
Some key things to know about unearned revenue:
- It is the opposite of earned revenue, which is revenue that has been invoiced and recognized as the result of goods or services provided.
- It is considered a current liability, meaning the product or service is expected to be delivered within 12 months.
- Common examples include:
- Annual software subscriptions paid at the beginning of the year
- Prepaid gift cards that have not yet been redeemed
- Deposits for events or travel that have not yet occurred
- The unearned revenue balance is drawn down over time and converted to earned revenue as the associated goods/services are delivered.
- Recording unearned revenue properly is important for accurate financial reporting in accrual accounting.
In summary, unearned revenue represents obligations that a company owes its customers for payment received in advance of delivery. It is not yet "earned" and is classified as a liability until the goods or services are provided.
Is unearned revenue recorded as income?
No, unearned revenue is not recorded on the income statement as revenue until it is “earned” and is instead found on the balance sheet as a liability.
Unearned revenue represents cash received from customers for products or services that have not yet been delivered or performed. It is essentially a prepayment by the customer for goods or services they have not yet received.
Some key things to know about unearned revenue:
- It is recorded as a liability on the balance sheet because the company owes goods or services to the customer in exchange for the prepayment
- It is not counted as revenue or income until the company fulfills its obligation by delivering the product or performing the service
- Once the product/service is delivered, the liability is reduced and revenue is recognized on the income statement
So in summary, unearned revenue sits on the balance sheet as a liability until the company earns it by satisfying its performance obligations to the customer. Only then can it be recorded as revenue on the income statement. This method of accounting matches revenue with its related expenses during the same reporting period.
Unearned Revenue Examples
This section will provide common examples of unearned revenue across different industries.
Subscription-Based Business Model
Many companies operate on a subscription-based business model where customers pay in advance for access to a product or service. For example, customers may pay $10 per month for a monthly software subscription.
When the payment is made, the company cannot recognize the full $10 as revenue since the service has not yet been fully provided. Instead, the payment is recorded as unearned revenue, a liability on the balance sheet. Each month as the service is delivered, $10 of revenue can be recognized on the income statement and the unearned revenue balance reduced accordingly.
This applies to any business with prepaid subscriptions, including:
- Software as a Service (SaaS)
- Media streaming services like Netflix and Spotify
- Meal kit delivery services
- Gym memberships
Recording unearned revenue allows these companies to properly match revenue with service delivery over the subscription term.
Retailer Gift Cards and Unearned Revenue
When a customer purchases a gift card from a retailer, the retailer receives cash but does not immediately provide any goods or services to the customer. Instead, the customer or gift recipient can use the gift card to make future purchases.
The payment for the gift card is considered a liability or unearned revenue for accounting purposes. The retailer cannot count the revenue until the gift card has been redeemed and goods have been exchanged. Only at the point of sale when the gift card is used can the revenue be recognized.
The unearned revenue account is reduced, and revenue is moved from the balance sheet to the income statement. Tracking unearned revenue from gift cards allows retailers to properly account for these advance payments.
Customer Deposits and Revenue Recognition
In some businesses, particularly service-based companies, customers may be required to submit a deposit before work begins. Common examples include deposits for home renovations, catering services, venue rentals, and customized orders.
Since the company has not yet delivered on the promised goods or services, this deposit payment can't be counted as earned revenue. The deposit is initially recorded as a liability under unearned revenue.
Once the project is complete and the customer accepts the work, the deposit payment can be reclassified as earned revenue on the income statement. The balance sheet liability is reduced accordingly. This process ensures revenue is recognized upon delivery rather than merely the promise of future services.
Using unearned revenue allows service-based businesses to account for the timing difference between receiving customer payments and satisfying contractual obligations.
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The Unearned Revenue Journal Entry Process
This section covers the journal entries to record unearned revenue transactions.
Recording Advance Payments: Debit or Credit
When a business receives an advance payment from a customer for goods or services that will be delivered in the future, this payment is considered unearned revenue. Here are the key things to know about the initial unearned revenue journal entry:
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Unearned revenue is treated as a liability on the balance sheet. It represents an obligation for the business to provide the goods or services to the customer in the future.
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Upon receiving an advance payment, the business will make a journal entry to debit cash or accounts receivable and credit unearned revenue. This records the increase in assets (cash) and the increase in liabilities (unearned revenue).
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The unearned revenue account is credited because the business has not yet earned the revenue. Crediting this liability account reflects that there is an obligation to deliver goods or services in the future to earn the payment that has already been received.
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In summary, the journal entry is:
Debit:
Cash/Accounts Receivable $X
Credit:
Unearned Revenue $X
This entry increases assets and liabilities equally. No revenue is recorded yet since it has not been earned.
From Unearned to Earned: Recognizing Revenue Over Time
As a business fulfills its obligation by delivering goods or services over time, the unearned revenue will be decreased and recognized as earned revenue. Here is the journal entry:
Debit:
Unearned Revenue $X
Credit:
Revenue $X
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This entry reduces the unearned revenue liability account and increases recognized revenue.
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The amount transferred matches the amount of unearned revenue that has now been "earned" by providing goods/services to the customer.
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Companies should transfer unearned revenue to revenue periodically as obligations are fulfilled, not just at once when the contract ends. This matches revenue earned to the period in which goods/services were provided.
In summary, unearned revenue represents a future obligation to customers that is fulfilled over time. Companies make journal entries to record advance payments in unearned revenue accounts, then transfer to revenue as obligations are satisfied.
Unearned Revenue in the Balance Sheet
This section explains unearned revenue's treatment as a current liability on the balance sheet.
Classifying Unearned Revenue as a Liability
Unearned revenue is classified as a liability on the balance sheet because it represents money received by a company for goods or services that have not yet been delivered or performed. Here are some key points about classifying unearned revenue as a liability:
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Unearned revenue is essentially an obligation that a company owes to its customers - the company has received payment but still needs to deliver the product or service. This creates a liability on the financial statements.
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GAAP (Generally Accepted Accounting Principles) requires that unearned revenue is recognized as a liability, not revenue, until the performance obligations are satisfied.
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On the balance sheet, unearned revenue sits under "Current Liabilities" because it is typically earned or converted into actual revenue within 12 months or one operating cycle.
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The unearned revenue liability represents deferred revenue that will become "earned revenue" once the company fulfills its obligations to the customer in the future.
In summary, classifying unearned revenue as a liability reflects that the business has received cash but has not yet provided value to the customer. As goods and services are delivered over time, the liability is reduced and revenue is recognized.
Current Liabilities and Unearned Revenue
Unearned revenue is placed under current liabilities on the balance sheet because it is expected to become earned within one year. Here is some additional detail:
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Current liabilities are short-term financial obligations that are expected to be settled within 12 months or within the normal operating cycle of a business. This includes things like accounts payable, short-term debt, and accrued expenses.
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Unearned revenue fits into the “current liabilities” bucket because, in most cases, the related performance obligations tied to the payments will be fulfilled within the next year.
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For example, if a SaaS company receives a 12-month software subscription payment upfront, the unearned portion would sit in current liabilities and reduce over the subscription term as revenue is recognized.
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If for some reason the fulfillment of unearned revenue extends beyond 12 months, the balance sheet should reflect the long-term portion separately under “Long-term liabilities”.
In summary, unearned revenue sits under current liabilities on the balance sheet due to its short-term nature, representing obligations that the business expects to satisfy within the next year through delivery of goods and services. Monitoring changes in unearned revenue each period shows the pace at which deferred revenue balances convert into earned revenue.
Understanding the Unearned Revenue Formula
Unearned revenue, also known as deferred revenue, refers to money received by a business from a customer for products or services that have not yet been delivered or provided. It appears as a liability on the balance sheet because the business owes the customer the goods or services.
The unearned revenue formula calculates the amount of liability at any given point by comparing the revenue that has been deferred to the revenue that has been earned.
Calculating Unearned Revenue
Here are the steps to calculate unearned revenue:
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Identify the total amount of cash received upfront for the goods/services. This is the total unearned revenue amount.
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Determine the total number of months over which the goods/services will be provided.
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Divide the total unearned revenue amount by the number of months to determine the monthly unearned revenue amount.
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At the end of each month, subtract the monthly earned revenue amount from the total liability.
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The remaining balance is the updated total unearned revenue liability.
For example:
- Company XYZ receives $12,000 upfront on January 1 for a 12-month cleaning service contract.
- The total unearned amount is $12,000.
- Monthly unearned amount is $12,000/12 = $1,000.
- At the end of January, the company earned $1,000. The unearned liability is now $11,000.
- At the end of February, another $1,000 was earned, so the unearned balance is $10,000.
And so on until the end of the 12-month period when the balance reaches $0.
Adjusting Entries for Unearned Revenue
As goods and services are delivered each month, adjusting entries are required to recognize the earned revenue and reduce the unearned revenue liability.
When the monthly services are provided:
- Debit Unearned Revenue $1,000
- Credit Revenue $1,000
This recognizes $1,000 as earned revenue for that month and reduces the unearned revenue balance by the amount earned.
Monitoring and Managing Unearned Revenue
This section provides tips for monitoring unearned revenue balances and turning obligations into earned revenue.
Reviewing Unearned Revenue Aging Reports
Regularly reviewing unearned revenue aging reports is crucial for effective management. These reports categorize unearned revenue by age, allowing businesses to:
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Identify obligations nearing expiration. Proactively follow up with customers to ensure continued satisfaction. Offer renewals or expansion opportunities.
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Prioritize fulfilling obligations about to become overdue. Avoid reputation damage and customer disputes.
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Assess revenue recognition risk levels. Older unearned revenue indicates higher likelihood of non-delivery.
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Gain visibility into revenue flow health. Growing unearned revenue balances signal business growth. Declining balances may indicate issues.
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Strategize revenue investment. Focus sales efforts on customers with large unearned revenue to maximize revenue potential.
Best practice is reviewing aging reports monthly. Analyze trends over time and dig into root causes behind any concerning metrics.
Strategies for Converting Unearned to Earned Revenue
Businesses should actively work to fulfill obligations turning unearned revenue into earned revenue. Tactics include:
Deliver Outstanding Service
Provide exceptional service meeting or exceeding customer expectations. This makes renewal more likely, converting unearned balances into future earned revenue.
Offer Expansion Opportunities
Upsell additional products or services to existing clients. Expansion revenue is typically easier to earn from an established customer.
Automate Renewals
Automated renewal reminder emails can double renewal rates. Automating payment collection also helps smooth renewal conversion.
Maintain Close Customer Relationships
Proactively communicate to ensure satisfaction. Address issues early and accommodate reasonable requests to foster trust and loyalty. High satisfaction earns repeat business.
With robust customer relationships and operating processes, businesses can reliably turn unearned revenue obligations into realized sales. Monitoring aging reports provides visibility enabling targeted improvement efforts.
Is Unearned Revenue an Asset?
Unearned revenue is often misunderstood as an asset, but it is actually a liability on the balance sheet.
The Distinction Between Assets and Liabilities
The key difference between assets and liabilities lies in the flow of future economic benefits.
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Assets represent future economic benefits that a company owns or controls. For example, inventory that will later be sold for a profit is an asset.
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Liabilities represent obligations that a company owes, which will result in a future outflow of resources or economic benefits from the company.
Unearned revenue fits the definition of a liability because it refers to cash received for products or services that have not yet been delivered or performed. The company still owes the customer the goods or services in question, representing a future outflow of economic benefit.
Therefore, while the cash flow impact may make unearned revenue seem like an asset, it does not qualify as such from an accounting perspective. Proper classification is important for accurate financial reporting.
Implications of Misclassifying Unearned Revenue
Treating unearned revenue as an asset can distort key financial metrics and performance evaluations:
- Overstating net assets and equity on the balance sheet
- Inflating income statement metrics like revenue and net profit
- Presenting an overly optimistic picture of the business's financial health
It can also lead to faulty revenue recognition practices when the performance obligations tied to that revenue have not yet been fulfilled.
Overall, misclassifying unearned revenue can reduce transparency for investors and stakeholders. It is important for businesses to properly categorize unearned revenue as a liability in order to provide accurate and compliant financial statements.
Conclusion: The Role of Unearned Revenue in Financial Health
In summary, properly accounting for unearned revenue as a liability is critical for accurate financial reporting. Businesses should actively work to fulfill obligations in a timely manner to convert unearned revenue into earned revenue.
Summary of Unearned Revenue's Impact on Financial Statements
Unearned revenue, also known as deferred revenue, plays an important role in a company's financial statements:
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It is recorded as a liability on the balance sheet, representing obligations that the company owes to customers. As goods or services are delivered over time, this liability is reduced.
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It impacts the income statement by determining when and how revenue can be recognized. Revenue is only earned and recorded when obligations tied to unearned revenue are fulfilled.
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Changes in unearned revenue from one accounting period to the next must be properly presented on both the balance sheet and income statement.
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Metrics relying on revenue or liabilities, like working capital, may fluctuate depending on the level of unearned revenue.
Proper accounting treatment of unearned revenue is necessary for accurate financial reporting and performance analysis.
Best Practices for Managing Unearned Revenue
Businesses should develop strong financial processes and controls around unearned revenue:
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Closely monitor contracts and performance obligations that lead to unearned revenue balances. Have procedures in place to fulfill obligations on schedule.
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Forecast future revenue recognition from existing unearned revenue levels. This helps guide operational plans to deliver on obligations.
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Provide customers clear timelines and expectations for receiving goods and services tied to payments. Frequently update customers on progress.
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Review revenue recognition policies and ensure compliance with accounting standards for unearned revenue.
Actively managing unearned revenue enables businesses to improve relations with customers, smooth earnings, and enhance predictability of financial results.
