What Is Unearned Revenue?
Unearned revenue is money received for a service or product that has yet to be provided or delivered by an individual or corporation. It can be viewed as a down payment on products or services that will be delivered to the buyer at a later period by a person or corporation. The seller has a liability equivalent to the income collected until the item or service is delivered as a consequence of this prepayment. It is recorded under current liabilities because this is likely to be resolved within a year. Deferred revenue and advance payments are other terms for unearned revenue.
This concept occurs in accrual accounting. The revenue is recognized as unearned when a corporation receives cash, yet the items or services have not been delivered to the consumer. It is frequently connected with subscriptions, circumstances in which the seller has an advantage over the customer, or when the vendor provides the buyer with personalized items. For the seller, this is helpful in terms of cash flow. He now has the funds in advance and can use the buyer’s money to purchase the necessary raw materials.
Unearned Revenue – A Closer Look
Companies that provide subscription-based products or other services that need prepayments are the most likely to have unearned income. Prepaid rent, prepaid insurance, legal retainers, airline tickets, prepayment for newspaper subscriptions, and annual prepayment for software use are all examples. Receiving payment before a service is completed might be advantageous. Early cash flow can be utilized for a variety of purposes, including paying loan interest and acquiring more merchandise.
Recording Unearned Revenue
Unearned revenue is represented as a liability on a company’s balance sheet. This is because the money reflects items or services still owed to a client. The initial accounting entry is a credit to the unearned revenue account and a debit to the cash account. As income is earned, the balance in the unearned revenue account is reduced with a debit, and the balance in the revenue account is increased with a credit. On the balance sheet, the unearned revenue account is normally categorized as a current liability. Eventually, the prepaid service or product is recorded on the Income Statement as revenue as it is gradually supplied to the customer.
Instead, if a company were to recognize it all at once, revenues and profits would initially be overstated. Then, understated for the additional periods during which the revenues and profits should have been recognized. This is also a violation of the matching principle. The revenues are being recognized at once, while related expenses are not being recognized until later periods.
For example, consider a software company accepting $1,188 for a one-year subscription valued at $99/month. The amount is recorded as an increase in cash and an increase in unearned revenue. Both are balance sheet accounts, so the transaction does not immediately affect the income statement. As this is a monthly subscription, the liability or unearned revenue is reduced by $99 as each month passes. Conversely, the revenue is increased by the same amount and is reflected on the Income Statement.
Unearned revenue is generally reported on a company’s balance sheet as a current liability. However, if advance payment is for services or items that will be delivered a year or more after the payment date, this changes. Unearned income will still reflect on the balance sheet. But, it will be recorded as a long-term liability in such circumstances.
Unearned Revenue Reporting Requirements
A public firm must fulfill various requirements imposed by the Securities and Exchange Commission (SEC) on how it reports revenue. Revenue recognition is deferred if these conditions are not satisfied. According to the SEC, there must be collection probability, or the ability to make a reasonable estimate of an amount for the allowance for doubtful accounts. Further, there must be completed delivery or ownership shifted to the buyer. Also, a contract or persuasive evidence of an arrangement, and a determined price.
Unearned Revenue – Accrual Vs Cash Accounting
Businesses that accrue unearned revenue should record it as such for a number of reasons. First and foremost, future resources for product and service delivery must be prepared. A company may be selling something it can’t support or provide if they don’t have them. Additionally, the Securities and Exchange Commission (SEC) of the United States has revenue recognition reporting requirements for firms. Revenue recognition is a widely recognized accounting standard (GAAP) that governs the way revenue is recorded. Unearned revenue is recognized over time as the product or service is supplied, based on certain crucial events, in accordance with GAAP.
The SEC has set criteria for how revenue is recognized. The adoption of Accounting Standards ASC 606, makes revenue recognition rules now more uniform. They used to be industry-specific.
When Is Unearned Revenue Recognized?
According to ASC 606, businesses must recognize revenue when they have delivered products or services that are equal to the amount in exchange for those same products and services. This process includes the following 5 steps:
- Contract – Review the contract with the customer.
- Obligation – Identify what the business obligation is in the contract.
- Price – Determine the appropriate amount for the transaction.
- Allocate – Match that amount towards the contracted obligation as it is met.
- Recognize – Revenue is recognized when the business satisfies the obligation.
For example, consider an online publisher who pays upfront for a custom programmer and web development on their website.F The web development firm receives a $12,000 payment in advance. Per ASC 606, the web developer will look at what is contractually obligated for each accounting period. Next, they will compare what was obligated with what they actually did during that period. Finally, they will determine how much of the total of $12,000 it represents. For example, if they were obligated to and performed half of the total contract in the first 60 days, the web developer would recognize $6,000 in revenue for that period. As a result, the unearned revenue figure in current liabilities would drop by $6,000, and the cash could then be listed as a current asset instead using an adjusting journal entry.
Examples of Unearned Revenue
Morningstar Inc. is a financial services company that provides products and services to financial advisers and asset managers. Subscriptions are used to sell several of the company’s products. Many subscribers pay in advance and receive the product over time under this arrangement. As a result, the money is recorded as unearned revenue, or as Morningstar refers to it, deferred revenue. Morningstar reported $287 million in unearned revenue at the end of the second quarter of 2020, up from $250 million at the end of the previous year. The revenue is classified as a short-term liability. This is because the firm expects to be paid over the course of a year for services that will be supplied during that time.
Example 2 – Small Business
A homeowner buys a lawncare package in advance from a local landscaping company. The package is for three month’s worth of lawn maintenance at $500 per month. The total prepayment is $1500 which the client pays upfront. The landscape company enters $1500 as a debit to cash and $1500 as a credit to unearned revenue.
The landscape company records the accrued revenue earned on a monthly basis. The earned revenue is recognized with an adjusting journal entry called an accrual. At the end of the month, the landscaper debits unearned revenue $500 and credits revenue $500. The landscaper does so until the three months elapse and they have accounted for the entire $1500 in income both collected and earned or delivered.
Other Examples of unearned revenue are:
- A rent payment made in advance
- A services contract paid in advance
- A legal retainer paid in advance
- Prepaid insurance
Up Next: What Is the Debt To Capital Ratio?
A company’s financial leverage is measured by the debt-to-capital ratio. The debt-to-capital ratio is derived by dividing the total capital by the company’s interest-bearing debt, both short- and long-term obligations. Debt includes all interest-bearing debt. Shareholders’ equity may comprise common stock, preferred stock, and minority stakes or interests.
The debt-to-capital ratio is a liquidity metric. It compares the total liabilities of a firm to its total capital. It provides a good indication of how much of a company’s activities are supported by debt as opposed to capital. For small business owners, it offers useful insight to assess a firm’s risk profile before investing for expansion. At its core, it is a simple metric. Yet, it gives a quick thumbnail glimpse of how financially healthy your company is. Often, a company’s debt burden may appear to be excessive in raw figures. Nevertheless, the ratio may be well below acceptable risk limits when compared to the company’s overall capital.