What happens when a business receives payments from customers before a service has been provided? These types of prepayments are recorded as unearned revenue. Here’s how to handle this type of transaction in business accounting.
Unearned revenue explained
When a customer pays for products or services in advance of their receipt, this payment is recorded by a business as unearned revenue. Also referred to as “advance payments” or “deferred revenue,” unearned revenue is mainly used in accrual accounting. Due to the advanced nature of the payment, the seller has a liability until the good or service has been delivered. As a result, for accounting purposes the revenue is only recognized after the product or service has been delivered, and the payment received.
Examples 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. This would initially be marked as unearned service revenue because the company has received a full payment for services not yet provided. The full $50 would need to be recorded as unearned service revenue on the company’s balance sheet. As each month of the annual subscription goes by, the monthly portion of this total can be deducted and recorded as revenue.
Recording unearned revenue
As mentioned in the example above, when an advance payment is received for goods or services, this must be recorded on the balance sheet. After the goods or services have been provided, the unearned revenue account is reduced with a debit. At the same time, the revenue account increases with a credit. The credit and debit will be the same amount, following standard double-entry bookkeeping practices.
Advance payments are beneficial for small businesses, who benefit from an infusion of cash flow to provide the future services. An unearned revenue journal entry reflects this influx of cash, which has been essentially earned on credit. Once the prepaid service or product is delivered, it transfers over as revenue on the income statement.
There are a few additional factors to keep in mind for public companies. Specific recording criteria is outlined by the U.S. Securities and Exchange Commission (SEC) regarding revenue recognition. This includes collection probability, which means that the company must be able to reasonably estimate how likely the project is to be completed. There should be evidence of the arrangement, a predetermined price, and realistic delivery schedule.
Is unearned revenue a liability?
In short, yes. According to the accounting reporting principles, unearned revenue must be recorded as a liability. If the value was entered as an asset rather than a liability, the business’s profit would be overstated for that accounting period. According to the accounting equation, assets should equal the sum of equity plus liabilities. This would create an imbalance in the books.
If you don’t enter revenue received in the same accounting period that expenses were paid, this also violates the standard accounting principles. As a result, unearned revenue is a liability for any company that has already received payment without delivering the product. If the company failed to deliver, it would still owe that money to the customer so it cannot be recorded as revenue just yet. After delivery, the payment switches from liability to revenue.
Unearned revenues are usually considered to be short-term liabilities because obligations are fulfilled within a year. However, those wondering “is unearned revenue a liability in the long-term” could also be proven correct when looking at a service that will take longer than a year to deliver. In these cases, the unearned revenue should usually be recorded as a long-term liability.
The bottom line
Unearned revenue is a common type of accounting issue, particularly in service-based industries. By treating it as a liability for accounting purposes, you can keep the books balanced. It’s also useful for investment purposes, as unearned revenue can often provide fresh insight into a company’s potential future revenue.
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