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What Is Unearned Revenue?

unearned revenueunearned revenue
min read
August 21, 2023

Do you collect deposits from customers or bill them before delivering your product or service? If so, you have unearned revenue.

Unearned revenue isn't discussed as much as other financial concepts, such as cash flow or accounts receivable, but it can play an important role in your business finances

This article explains what unearned revenue is for small business owners. We’ll also go into how to account for it so you can make the most informed decisions when managing your business's finances.

What Is Unearned Revenue?

Unearned revenue is any money you've collected from clients in advance of providing goods or services. It’s also known as deferred revenue, prepaid revenue, or unearned income. In essence, it is income that you've received but not yet earned.

In financial accounting, unearned revenue is a liability on your balance sheet—not an asset. While you might deposit the money into your bank account, the revenue isn’t really yours until you deliver the product or service, so it shouldn’t show up on your income statement.

Is It a Short-Term or Long-Term Liability?

In many cases, any unearned revenue on your books will be a short-term liability (also known as a current liability) because you expect to earn the revenue within the current accounting period—usually within the next 12 months.

However, in some cases, your deferred revenue might be a long-term liability. This is the case if you don't expect to either earn the revenue or return the deposit to your customer within the next year. 

For example, let’s say you collect a security deposit from a tenant on a three-year lease. Because you don’t expect to convert it to revenue within the next 12 months, that deposit would be a long-term liability account.

When Is Unearned Revenue Used?

Unearned revenue is mainly used in accrual accounting, which recognizes revenue as soon as its earned.  

Meanwhile, companies that keep their books on a cash accounting basis don't have an unearned revenue account. They simply recognize revenue when cash comes in and recognize expenses when cash goes out.  

Examples of Unearned Revenue

Examples of unearned revenue include:

Let’s look at one of these in depth:

Say you own a lawn maintenance company. At the beginning of the year, you present your clients with an alternative payment option: If they pay in advance for a year of your services, you'll give them a 10% discount. So instead of paying $200 per month, they'll pay $2,160 annually, which works out to $180 per month. 

Customer A takes you up on your offer and sends you an advance payment of $2,160 in January. Recording the entire $2,160 as revenue in January wouldn’t be right because the prepayment covers 12 months of lawn maintenance services. If you don't provide the agreed-upon services, you'll be obligated to refund Customer A's money.

Instead, you would record the $2,160 as unearned revenue. Then, at the end of each month, you can recognize revenue for that month with a journal entry.

Now, let's cover what those journal entries look like.

How to Record Unearned Revenue Journal Entries

In double-entry bookkeeping, journal entries contain two components: a debit and a credit.

So returning to the example above, when you received payment for future services from Customer A at the beginning of the year, your entry to record it in your books needs a debit and a credit. Your initial entry would be:

Initial Entry Showing Payment for Future Service
Account Debit Credit
Cash $2,160
Unearned Revenue $2,160

By the end of January, you've performed that month's lawn maintenance services, so you want to move the monthly portion of the customer's deposit to your income account. Your adjusting journal entry would be:

Adjusting the Entry after Providing Service
Account Debit Credit
Unearned Revenue $180
Revenue $180

At the end of each month, you make this same journal entry until you’ve recognized all of Customer A's revenue in your books.

However, say after six months, Customer A decides they no longer need your service. Assuming you don't have a clause in your contract stating that all payments are non-refundable, you would refund half of their annual subscription fee. Your entry would be as follows:

Adjusting the Entry for a Refund
Account Debit Credit
Unearned Revenue $1,080
Cash $1,080

What Types of Businesses Have Unearned Revenue?

Any business that accepts advance payments or upfront customer deposits can have unearned revenue. Some examples of businesses that could have unearned revenue on their books include:

  • An insurance company that collects prepaid insurance premiums from customers
  • A SaaS company that collects annual subscription fees from customers
  • Businesses in the hospitality industry that refund airline tickets or hotel fees if they cancel their reservations
  • Law firms and other professional service providers that have retainer agreements with their clients
  • Landlords that collect advance rent payments from tenants
  • Manufacturers that require customers to pay a percentage of the total order as a down payment
  • A publishing company that sells annual subscriptions to its magazines

The important thing to remember is that until the products or services have been delivered to your customer, the money received should stay in the unearned revenue account, as it's not yet recognizable as income.

Why Not Just Record Customer Deposits as Revenue?

Recording customer deposits as revenue can be tempting. However, there are a couple of reasons why this generally isn't a good idea.

First, recording customer deposits as revenue doesn't accurately reflect the company's financial position. For example, say you collect a $5,000 deposit from a customer in December and recognize the full payment as revenue. 

In your year-end income statement, your revenues would be overstated by $5,000 because you didn't actually earn that money yet. If your customer cancels their order in January and you have to refund their deposit, you will start the year with a big expense: a $5,000 customer refund. And what if you already spent that money?

Also, if you're required to issue financial statements prepared according to generally accepted accounting principles (GAAP), then you're required to use the accrual method of accounting— which recognizes income only when the goods or services have been delivered. 

So recording customer deposits as revenue would lead to inaccurate financial statements that don't comply with GAAP.

How to Manage Unearned Revenue

Managing unearned revenue is key for any business that collects payments before delivering goods or services. Here are some tips on how to do this effectively:

  • Create clear policies: Make sure you have a clear policy in place for handling customer deposits and payments.
  • Stick to GAAP guidelines: If you issue GAAP financial statements, make sure you follow GAAP guidelines and recognize income only when the goods or services have been delivered.
  • Keep accurate records: Keep accurate records of all customer transactions, so you can track and manage unearned revenue effectively.
  • Regularly review your records: Review your company’s balance sheet and income statement regularly to ensure your unearned income is recorded accurately.
  • Put controls in place: Set up appropriate internal controls to ensure that you are only recognizing revenue once the goods or services have been provided.
  • Categorize refunds correctly: Ensure that any refunds due to customers are accounted for correctly in the financial statements.

By following these tips, your small business can manage its unearned revenue efficiently and accurately. In doing so, you'll be able to report financial performance and ensure you're not overstating the results of operations or understating expenses.

Set Up Your Accounting Processes for Unearned Revenue

Accounting for unearned revenue properly is essential for accurate financial reporting and understanding where your business stands. When done right, it brings clarity and accuracy to your financial reporting.

With the user-friendly accounting software options available today, it's easy to track and manage your unearned revenue without being bogged down by thousands of manual entries.

Hopefully, the information we shared today will help clarify how your businesses can account for unearned revenue correctly. Remember, accurate record-keeping is worth its weight in gold!

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