What is Unearned Revenue?
Unearned Revenue refers to customer payments collected by a company before the actual delivery of the product or service.
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Unearned Revenue in Accrual Accounting
The recognition of unearned revenue relates to the early collection of cash payments from customers.
According to the revenue recognition principle established under accrual accounting, a company is not allowed to recognize revenue on its income statement until the product or service is delivered to the customer.
In the case of unearned revenue, since the customer has yet to receive the benefits associated with their payment, the revenue is recorded as “Deferred Revenue” on the company’s balance sheet.
Once the transaction is completed – i.e. the company fulfills its obligation to deliver the product or service the customer already paid for – the payment is at that point formally recognized as revenue because it is now “earned”.
Per accrual accounting reporting standards, revenue must be recognized in the period in which it has been “earned”, rather than when the cash payment was received.
Unearned Revenue Example – Multi-Year Customer Contract
Common examples of scenarios in which unearned revenue is recorded are the following:
- Unused Gift Cards
- Annual or Multi-Year Subscription Plans
- Insurance Premium Payments
- Prepayment on Rent
- Future Service Agreements with Product Purchases
- Implied Rights to Future Software Upgrades
Suppose a SaaS company has collected upfront cash payment as part of a multi-year B2B customer contract.
Initially, the total amount of cash proceeds received is not allowed to be recorded as revenue, despite the cash being in the possession of the company.
From the date of initial payment, the payment is recorded as revenue on a monthly basis until the entirety of the promised benefits is confirmed to have been received by the customer.
Any remaining amount of unearned revenue from month to month is recorded on the balance sheet in the “Deferred Revenue” line item, which represents the value of all cash collections ahead of the actual delivery of products/services.
Unearned Revenue – Liability or Asset?
Unearned revenue is recorded on the liabilities side of the balance sheet since the company collected cash payments upfront and thus has unfulfilled obligations to their customers as a result.
Unearned revenue is treated as a liability on the balance sheet because the transaction is incomplete.
More specifically, the seller (i.e. the company) is the party with the unmet obligation instead of the buyer (i.e. the customer that already issued the cash payment).
- Current Liability: If the terms associated with the prepayment are expected to be taken care of within twelve months, then the unearned revenue is recorded as a current liability.
- Non-Current Liability: If the payment is received in advance for delivery after more than twelve months – e.g. a multi-year contract – the amount where delivery is not expected within the current year is recorded in the non-current liability section of the balance sheet.
Certain contracts and customer agreements can also contain provisions stating contingencies where an unexpected event can provide the customer with the right to receive a refund or cancel the order.
Unearned Revenue vs. Accounts Receivable
While unearned revenue refers to the early collection of customer payments, accounts receivable is recorded when the company has already delivered products/services to a customer that paid on credit.
The concept of accounts receivable is thereby the opposite of deferred revenue, and A/R is recognized as a current asset.
In the case of accounts receivable, the remaining obligation is for the customer to fulfill their obligation to make the cash payment to the company in order to complete the transaction.
Journal Entry Accounting for Unearned Revenue
Unearned revenue is not recorded on the income statement as revenue until “earned” and is instead found on the balance sheet as a liability.
Over time, the revenue is recognized once the product/service is delivered (and the deferred revenue liability account declines as the revenue is recognized).
For example, imagine that a company has received an early cash payment from a customer of $10,000 payment for future services as part of the product purchase.
We see that the cash account increases, but the unearned revenue liability account also increases.
If the service is eventually delivered to the customer, the revenue can now be recognized and the following journal entries would be seen on the general ledger.
The unearned revenue account declines, with the coinciding entry consisting of the increase in revenue.