Many companies get payments from clients before delivering a service or product. In simple terms, it is the payment that customers make ahead of time. This is an important accounting term known as unearned revenue.
This unearned revenue is later added to financial accounting when the company delivers the service or the product. However, this is only applicable when the business meets the below criteria as per the Securities and Exchange Commission (SEC).
Here we will present the proper information related to unearned revenue that will cover its example, its type, and calculation.
What Does Unearned Revenue Mean?
Unearned revenue is defined as the payment the company receives for the product or service offered to the customer but accessible after a certain time. It is also known as prepaid revenue that companies gain before giving the service to the client.
Retainer agreements, airline tickets, and subscription-based software are some of the businesses where this prepaid revenue occurs.
Unearned revenue helps to ensure financial statements’ accuracy. Companies always adhere to the matching principle by deferring recognition of revenue. Unearned revenue always reflects customers’ trust and commitment.
As per the SEC standard, there must be the following points to consider unearned revenue in financial statements.
- A determined price
- Collection probability
- Persuasive evidence
- Completed the delivery
Financial Accounting Standards Board (FASB) and the Securities and Exchange Commission established Generally Accepted Accounting Principles (GAAP). It guides the companies on recording prepayments as unearned revenue.
Many financial reporting criteria exist based on GAAP. All public companies must meet these criteria to recognize revenue. In the event of failing to meet any of the criteria, the company must stick to revenue recognition guidelines.
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The Importance of Unearned Revenue
Unearned revenue always plays a vital role in the reporting of a business. It contains the advance payments that are received from the customer for the inaccessible service or the product.
Unearned revenue transforms into revenue on the income statement upon delivery of the service or product. Early receiving funds is highly beneficial for a company. It increases the cash flow that can be utilized for business functions.
Companies use funds to cover operational expenses and also invest in various growth opportunities. Unearned revenue also serves as an indicator of performance in the future. It also offers insight into the company’s performance.
What Is an Unearned Revenue Example?
Some of the common scenarios of unearned revenue in business are as follows:
- Insurance premium
- Rental payment
- Any unused gift cards
- Service agreement with product purchase
- Annual subscription plan
Let’s understand unearned revenue through an example. Suppose a person is a regular user of an online shopping app. The application has introduced a new service that includes free shipping and gifts with a $50 subscription. The person will pay $50, but that will be unearned revenue for the company. The payment is received by the company but the customer availed of none of the services.
Do We Consider Unearned Revenue a Liability?
Whether unearned revenue should be categorized as a liability or not. This is an often-asked question among professionals. The simple answer is yes. Unearned revenue is liable as per the accounting reporting principle. Unearned revenue is documented on the liabilities side of the balance sheet.
Liability can be in any form, and the company has to owe. It can be in the form of a small electricity bill or a mortgage of a complex.
The unearned revenue is listed as a liability, and it presents that you have not given the service. This applies until you repay them.
Types of Unearned Revenue Reporting
Certain rules and guidelines for recognizing unearned revenue are applicable. There are two ways of reporting a company’s financial statements.
Liability Method
The other name of this method is the deferred method. It is a common approach to reporting unearned revenue. The entire amount is documented as a liability on the balance sheet when the advance payment is received. As there is an obligation to the customer to deliver the goods, it is a major cause of existing liability.
Income Method
The income method is the next approach to reporting unearned revenue. Instead of being classified as a liability, unearned revenue is recognized as income upon receipt of payments.
If there is high certainty that goods and services will be delivered at a low cost, and the payment is upfront and non-refundable, then the income method is still a useful approach.
What Is the Difference Between Unearned Revenue and Deferred Revenue?
Unearned revenue and deferred revenue are often swapped when they are utilized. However, their concept in accounting is slightly different. These are two different terms concerning the same idea.
Unearned revenue refers to the advance payment the company receives for offering goods and services. But these goods and services are available for the customer in the future. Once the goods and services are received, the unearned revenue is termed as revenue on the income statement.
Deferred revenue includes any revenue that is not recognized as income because of non-delivery of goods or services. It is never recognized immediately because of contractual obligations or accounting principles. Deferred revenue is a ‘yet to be earned’ known term. Deferred revenue in another form known as deferred income. Unearned revenue and deferred revenue are crucial for accurately recognizing revenue.
How Should Unearned Revenue be Recorded?
Unearned revenue is always considered an important financial statement on the business balance sheet. It is generated by accounting software.
On receiving unearned revenue, the first record will be made on the business balance sheet and then in the journal entry. Many professionals are often confused about whether to consider unearned revenue as a debit or credit.
The initial step is to debit prepaid revenue under current liabilities. This can also be done under a specific unearned revenue account type.
Adding unearned revenue on the balance sheet
Unearned revenue can be reported on your business’s balance sheet. This will be the most significant financial statement that you can generate. The entry will be documented in the short-term liabilities section. You need to credit the unearned revenue and debit the cash entry because this is a cash increase for the business.
Make journal entries for any unearned revenue
The initial step in this process is the unearned revenue entry in the books as a cash account debit. The amount is the same for credit and debit. Recording each transaction in two accounts is essential. The initial journal entry indicates that the company receives cash for credit earned.
Suppose a SaaS company makes an advance collection of $30,000. The cash account will be debited while the unearned revenue account will be credited with this amount. Each transaction must be recorded in two separate accounts.
Adjusting journal entries
Business owners can make an adjusted entry when the business provides the product or service paid for. You need to debit the unearned revenue account and credit the product or service revenue account simultaneously. This process requires two journal entries: one for the unearned revenue and another for the earned revenue. This is an unearned revenue journal entry.
Let’s understand with an example. Assuming a SaaS company Y provides services worth 20% of the prepaid revenue, there will be a $8,000 debit to the unearned revenue account. On the other hand, credit will be on the service revenue account of the same amount i.e. $8000.
How to Calculate Unearned Revenue?
Monthly unearned revenue can be calculated by dividing the total amount by the number of months for which the service was provided.
Let’s assume you accept $3000 to clean the vehicle for 6 months.
3000/6 = 500
It is an example of a monthly service. Similarly, you can calculate unearned revenue.
Assume the landscaping business gets $46,000 from the client under the annual plan. The quarterly unearned revenue will be $46,000/4 = 11,500
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Conclusion
Unearned revenue is a crucial term of financial management. It addresses the commitment and trust between companies and clients. Businesses can also maintain transparency by accurately accounting for unearned revenue. Financial stability is also gained by effectively managing unearned revenue. Its contribution is vital to the company’s overall success and sustainability.
