“Companies that get confused, that think their goal is revenue or stock price or something. You have to focus on the things that lead to those”.
- Tim Cook
What is Unearned Revenue?
Unearned Revenue is like a prepayment. Before the service is provided or goods are delivered, advance payment is done. In accounting terms we call it Unearned Revenue. Because we are yet to offer goods/services in return of the money we received.
Because of this payment, the seller has a debt of the amount received as unearned revenue till the goods/services are delivered. Since, it has to be settled within one year, it is shown under the Current Liabilities in the financial statements of the company.
Some other names of Unearned Revenues are- Advanced Payment, Prepayment, Deferred Revenue. In order to settle the debt of the seller, goods must be timely delivered. Once the goods are delivered the debt is canceled and the unearned revenue becomes revenue.
This revenue is then recognised in the income statement. You might think which companies are involved in receiving advance payments for their products. Companies that follow a subscription model or products that need advance payments are some examples.
Examples where Advance payments are done:
Rents
Annual Subscriptions
Prepaid Insurance
Software as a Service [SaaS] Companies
Service Contracts
Legal Retainers
Receiving money earlier can benefit the company as it increases the cash flow to settle daily needs as well interest payments and inventory management. The term is used in the accrual system of accounting.
The Accrual System of accounting says that we recognise the revenue when the payment is received irrespective of when it is received. Therefore, when we receive early payment for the goods yet to be delivered, we record it in the books of accounts as unearned revenue.
Example of Unearned Revenue
Here is an example to understand the whole concept of advance payments. Suppose a guy named Ali who uses Amazon.com and its services recently found out about Amazon Prime. Now he wants to use it and make an account on it.
The services offered are what Ali wants. He also wants early deliveries, free shipping, music and movies. So he buys the annual subscription of Amazon Prime for $80. Now, from Amazon’s perspective this $80 received as annual subscription is Unearned Revenue.
Reason being, the company received full amount for 12 months even though the services are yet to be provided to Ali. When Amazon will prepare its books of accounts, it will put the amount of annual subscription in the balance sheet as “Unearned Revenue”.
What will happen after 1 month when the services are provided and the amount is already accounted for in the books? As it is a subscription model Ali took an annual subscription i.e. 12 months. When the first month ends, Amazon would have offered services to Ali for that month.
Therefore, from $80 we will calculate the monthly revenue. To calculate the monthly revenue we divided $80 by 12. We get $6.67 per month. So, Amazon will subtract $6.67 from $80 and record it as revenue for the 1st month.
This process will continue until the annual subscription comes to an end i.e. end of 12th month. If Ali wants he can continue the annual subscription again and the company will follow the same process.
In simple words, all the amount when received is recorded as Unearned Revenue in the Balance sheet and as the goods are delivered and services are rendered we take the proportionate amount from the total and record it as Revenue earned.
Importance of Unearned Revenue
Market leadership can translate directly to higher revenue, higher profitability, greater capital velocity, and correspondingly stronger returns on invested capital.
- Jeff Bezos
Unearned revenue is a debt for the suppliers but simultaneously it has many benefits as well.
You get the payment earlier - Cash is always needed for daily working capital management and petty expenses. But you cannot rely on the customer 100% for timely payment. Not getting timely payment can lead to issues and dry spells in daily needs.
Therefore, getting an early payment or advanced payment is great for small businesses and companies to finance their daily needs. Once your cash flow remains positive, you will get a drive to perform better and fulfill all the deliveries and projects on time.
Increase in your working capital - In order to carry out big projects and timely completion before deadlines you need to have working capital. Managing the payroll costs and daily expenses can be difficult for contractual projects.
You can always reach a bank and get an approved loan. But what about the interest? Interest payment can also become a headache for small businesses. Therefore, getting deferred revenue from customers is a quick way to replenish your working capital.
Great for clients to manage big investments - For the clients that have invested in big projects, paying early or in small installments can be a big relief. It not only helps them but also helps the contractors and supplies to make better relationships with their clients.
Suppliers can offer discounts for early payments. It will improve their cash management as well as yours. You must have heard of many websites that offer online tuition and coachings to students.
They always have a discount on early payment. It is a way to attract more customers and get early payments at the same time.
Also Read | What is Revenue Deficit?
Recording Unearned Revenue
When you receive advance payments, you have to record it in the books of accounts immediately to avoid errors and confusions on a later date. Balance sheets must be updated with unearned revenues. But first you need to pass the journal entry for the same.
When the revenue is earned, you have to pass an adjustment entry for the same and reverse the effect of unearned revenue. Given below is how you will record unearned revenue in the books.
How to record Unearned Revenue
Finding Unearned Revenue on the Balance Sheet
When preparing your balance sheet through accounting software, you need to report the amount of the Unearned revenue. Under the head “Short term liabilities” or in some cases “Long term liabilities” this amount will be recognised.
As it will increase the cash in the business, you need to debit the cash accounts and credit the Unearned revenue account simultaneously. Where you do not have Unearned Revenue as a line item in the Balance sheet, you will put it under Current Liabilities.
As we follow the double entry system in account and assets balance should always match the liabilities total in the balance sheet. We need to record unearned revenue in the asset side as well. But under which head?
The amount of deferred payment will be recorded under prepaid revenue to increase the asset side as well. By recording on both the sides we can balance the equation.
Making journal entries for Unearned Revenue
When you receive the amount of unearned revenue you debit the cash account and credit the unearned revenue account. Both the debit and credit is done with the same amount keeping in mind the double entry system.
Then, both these are recorded in separate ledger accounts as well. The first entry that you make is to record the entry of unearned revenue in the business. It means that the business has received the cash with respect to unearned revenue.
For example- On 1st January, Company Y received $10,000 as unearned revenue from one of its customers. The journal entry for the same will be as follows:
You debit the cash account with $10,000 and then credit the Unearned Revenue account with $10,000.
Adjusting Journal Entries
Now that you have passed the journal entry of advance payment and then reported in the Balance sheet. The company delivers the product and provides the services in respect to the advance and the unearned revenue becomes revenue earned.
What treatment will be done now? Now, an adjusting journal entry will be passed. Or in simple language, a reverse entry will be passed to nullify or cancel out the unearned revenue account.
For this, you debit the unearned revenue account with the amount that has become revenue earned now and then credit the goods account or service account whichever is relevant.
In short, 2 entries will be made. One when you receive the amount of unearned revenue and the second when you actually realize it.
Taking the previous example. Let us assume that Company Y offered services but only up to 30% of the amount received till January end. The journal entry for it will be as follows:
You will debit the unearned revenue account with $3,000 [30% of $10,000] as 30% services are rendered from the total amount of unearned revenue. Then you credit the service account by $3,000.
Also Read | Revenue and Turnover
There are lots of confusions in the minds of people when they hear Unearned Revenue. Unearned Revenue is always a liability on the shoulders of the seller. It is because the company owes the customers until the product is delivered to them.
Advance revenues are not an asset. They only offer some advantages to businesses. If the sellers fail to provide the goods within the stipulated period then it does not mean that you can record it as revenue earned.
For companies offering services, Unearned revenue has always been an accounting issue. They often make mistakes when recognizing it. Some do not record it while some record it on the liability side just for the sake of balancing the books of account.
If a company wants to invest and look at the bigger picture then Unearned revenue can be put to a lot of uses. Investments are done for a longer term which is mostly more than 1 year. But unearned revenue is recorded under current liability. How does it work?
In some cases it is within the accounting principals to record the amount of advance revenue as long term liability.