Unearned Revenue

What Is Unearned Revenue?

Unearned revenue is the amount of money received by a company for the goods and services that are yet to be sold or rendered.

Unearned revenues are recorded in the books of accounts as a liability as they give rise to goods and services that are due. They are under liabilities until the services or goods are delivered.

When the goods and services are supplied/rendered, the liability is transitioned into revenue on the income of the organization.

Unearned revenues are quite common in subscription-based businesses that necessitate prepayments. These prepayments can benefit organizations by providing cash flow for business operations.

Some of the examples include prepaid rents, insurance, airline tickets, and annual software subscriptions.

Unearned revenue is classified under the head of current liability but, can also be recorded under long-term liability depending upon payment schedules.

Understanding Unearned Revenue

Unearned revenue is also known as Deferred Revenue. It is one of a few crucial accounting concepts where businesses receive the amount for goods and services that are yet to be provided.

Unearned revenue plays a pivotal role in cash management since it provides the organization with an inflow of cash that can be used for many activities.

When unearned revenue is managed appropriately, accurate financial reporting and compliance with regulatory standards established by organizations such as the U.S. Securities and Exchange Commission (SEC) are guaranteed.

Accounting treatment of Unearned Revenue includes:

1. Unearned revenue is recorded as a liability on the balance sheet initially in the event of receiving payment in advance.
2. Once the goods and services are delivered and executed, unearned revenue decreases with a debit while the revenue increases with a credit.
3. Any failures in recording the earned revenues could lead to financial misrepresentation and non-compliance with accounting standards.

In conclusion, organizations must comprehend unearned revenue in order to properly manage their finances.

Companies maintain appropriate accounting procedures and guarantee transparency in their financial statements by classifying prepayments as liabilities until services are rendered.

Revenue vs. unearned revenue

Revenue is when a sale is made, or a service is provided to the customer, which is paid for by them. Once the money is received, it is put into the revenue account, and at the end of the period, the revenue is used in the income statement.

Revenue must only be reported when it is unearned, which is due to the tax obligation on the revenue that is earned. Overstating the revenue will also overstate the tax obligation of the organization and will lead to them paying more money than they need to. 

Revenue is only reported when the service or good is provided, and the money is paid for. Revenue is only unearned when the customer pays the amount owed before the good or service is provided; when the opposite occurs, it is reported as accounts receivable. 

However, unearned revenue is the revenue received before it is earned. When the customer pays the money beforehand, it would be seen as unearned as it was received but not earned due to the service or good not being provided.

It is different for goods and services. In terms of goods, unearned revenue occurs when the money for the goods has been paid, but the goods have not been delivered to the customer.

Unearned revenue from services occurs when money is paid, but the service has not yet been performed. This means that the revenues aren’t earned and thus cannot be reported as revenue until the service is carried out.

Differentiating between revenue and unearned revenue is important to an organization, as the difference between the two leads to them being accounted for differently. Consent monitoring is also needed to adjust the changes.

How Unearned Revenue is Recorded

There is a difference in recording the revenue when it is earned and when the revenue is unearned. The main differences are the accounts they go to and how to report them in the general journal. This is an important skill to have.

It must be a skill learned by those preparing the organization's financial reports, as negative repercussions can occur if they are not placed in the right accounts. Revenue has tax obligations, whereas the unearned amount doesn't.

The recorder of the transaction must be aware of the accounting standards and the rulings that are in place and make sure they record the transaction accurately for the financial reports to show an accurate and fair view of the organization’s performance.

How Is Revenue Recorded?

When revenue is recorded in the general ledger, there is a certain way to do it. This is because the revenue received ends up on the income statement, and the cash is on the balance sheet of the organization's financial reports.

There is also another entry for the inventory taken out of the organization or the inventory used to perform the service for the customer. These amounts need to be updated on the statement of financial position and the income statement.

When it is in stock, there is also this entry:

How Is Unearned Revenue Recorded?

The journal entry needs to be separated from the actual revenue because one has a tax obligation, and the other is considered a liability to the organization and is not used to determine the tax obligation.

The journal entry is:

Then, when the organization completes the transaction by either performing the service or delivering the goods to the customer, it needs to adjust the journal entry for the unearned amount, which is done by debiting the unearned and crediting revenue.
 
The journal entry to adjust is:

This adjustment changes the value from liability on the statement of financial positions on the organization's reports to the income statement of the organization's reports. It is used to determine their tax obligation.

When Half Is Prepaid, Then You Split Between The Two

Sometimes the customer will pay half of the money before the service or good is provided and then pay the rest after the job is done. 

When this happens, sometimes the transaction is recorded differently, resulting in the revenue being overstated and liabilities being understated. 

When the customer pays half before the job is done, there still only needs to be one entry because the other half has not been paid for, nor has any service or good been provided (if they had, it would be accounts receivable). 

The journal entry is:

When they pay the rest and complete the transaction, they need to adjust the accounts. They do this by adjusting the half that was paid before the goods and services were provided and adjusting them to revenue.

The journal entry is:

Benefits Of Unearned Revenue

Though investors should be aware that the shift in the balance may be the result of a change in the business, unearned revenue can provide hints about future revenue.

Some of the benefits are discussed below.

Decreases The Chance Of Bad Debts

The organization that sells its goods and services can decide if it will accept sales on credit or if it will take prepayments. Each type has certain advantages, but prepayments have one main advantage: they decrease the bad debt expense.

The organization's benefit is that the money is already paid. If the money for the goods and/or services is already paid, there is no debt, eliminating the chance of the debt defaulting.

This decreases the number of bad debts as the customer has already paid the money.

Since customers deem this prepayment for their goods and services as their assets, it adds to their sense of security that the deliverables will be delivered as promised. This, in turn, contributes to customer satisfaction and loyalty.

Increases Cash On Hand

It increases the organization's cash on hand as they have more money. If they start getting more payments rather than selling on credit, the organization will have more money and can pay some short-term obligations.

It means that when the organization can pay off some current debt, it can do it quickly with the cash on hand.

Increases Working Capital

By having the payments for the goods and services in advance, businesses can optimize their working capital, providing them with an avenue to take on projects or invest in scaling opportunities that need upfront capital.

Limitations Of Unearned Revenue

Unearned revenue is typically listed on a company's balance sheet as a current liability. If upfront payments are made for products or services that must be delivered 12 months or more after the payment date, then this is adjusted.

In these situations, the unearned revenue will show up on the balance sheet as a long-term liability.

If there isn't any proper tracking of unearned revenues, they can result in a number of disadvantages and may bring a lot of reporting challenges.

Some of the limitations of unearned revenues are discussed below.

Accounting Complexity

Managing unearned revenue requires adherence to specific accounting guidelines and standards. The latest standard is the ASC606.

This introduces the complexity of financial reporting, especially with businesses that have different revenue streams.

Money Is Not Yours

One limitation is that the money does not belong to the organization. The money received in advance by the organization is for goods and services that are yet to be provided. 

That is why it is stated as a current liability in the statement of financial position for the organization and must be credited when adjusted.

The current ratio is one that can be negatively affected as current liabilities increase while current assets don't. The increase in unearned revenue will make the organization appear less liquid.

Overstatement Of Profit

Recording unearned revenues and similar prepayments can be challenging. Most commonly, unearned revenue is wrongfully recorded as an asset instead of a liability. 

This mistake can lead to an overstatement of profits, which can lead to misleading decision-making and create discrepancies in financial reporting.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Accrual Accounting
• Cash Flow Statement
• Modified Cash Basis
• Revenue Recognition
• Three Financial Statements