Unearned Revenue: Definition and How to Record It

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.

Unearned revenue is a critical concept for businesses to understand, both from an accounting perspective and a strategic one. Careful management of unearned revenue is essential for accurate financial reporting, cash flow management, and meeting customer obligations. At the same time, unearned revenue can provide valuable opportunities for cash flow and growth when managed effectively as part of a company’s overall business strategy.

Without this, they might struggle to fund materials, labor, or production. However, in each accounting period, you will transfer part of the unearned revenue account into the revenue account as you fulfill that part of unearned revenue are the contract. In addition, deferred revenue improves financial transparency, helping investors and analysts assess future business potential.

Recording Unearned Revenue

It illustrates that though the company has received cash for its services, the earnings are on credit—a prepayment for future delivery of products or services. You record prepaid revenue as soon as you receive it in your company’s balance sheet but as a liability. Therefore, you will debit the cash entry and credit unearned revenue under current liabilities. After you provide the products or services, you will adjust the journal entry once you recognize the money. Unearned revenue is recorded at the time of payment and then adjusted over time.

Deferred vs. unearned revenue: Key similarities

• Many professional service providers, such as law firms, marketing agencies, consultants, and IT service providers, require clients to pay a retainer before work begins.
• He does so until the three months is up and he’s accounted for the entire $1200 in income both collected and earned out.
• With platforms like Ramp, businesses can automate revenue tracking, eliminate manual data entry, and ensure revenue is recognized accurately.
• The debit and credit are of the same amount, the standard in double-entry bookkeeping.
• SaaS is the largest segment of the public cloud services market, with spending projected to grow 20% to $247.2 billion in 2024.

Software-as-a-Service (SaaS) companies frequently receive prepayments for annual subscriptions. Retainers provide financial stability for businesses that offer ongoing or long-term services. Most professional service firms use a retainer model to manage workload, reduce financial uncertainty, and ensure clients stay committed.

Over time, the revenue is recognized once the product/service is delivered (and the deferred revenue liability account declines as the revenue is recognized). The related account for advance payment that they received should be recognized as a liability in the balance sheet; no revenue should be recorded in the income statement yet. Unearned revenue refers to the money small businesses collect from customers for a or service that has not yet been provided. In simple terms, unearned revenue is the prepaid revenue from a customer to a business for goods or services that will be supplied in the future. Poor unearned revenue management can lead to financial misstatements, tax penalties, and compliance risks.

When the revenue is actually earned:

The company, however, is under an obligation to provide the goods or render the service, as the case may be, on due dates for which advance payment has been received by it. As such, the Unearned Revenue is a Liability till the time it doesn’t completely fulfill the same, and the amount gets reduced proportionally as the business is providing the service. It is also known by the name of Unearned Income, Deferred Revenue, and Deferred Income as well. Some examples of unearned revenue include advance rent payments, annual subscriptions for a software license, and prepaid insurance. The recognition of deferred revenue is quite common for insurance companies and software as a service (SaaS) companies.

For companies managing multiple client retainers, tracking prepayments, and revenue recognition can become complex. Ramp simplifies this by offering bulk transaction categorization and AI-suggested accounting rules, ensuring each retainer is recorded and recognized accurately. For simplicity, in all scenarios, you charge a monthly subscription fee of $25 for clients to use your SaaS product.

• The personal trainers enters $2000 as a debit to cash and $2000 as a credit to unearned revenue.
• Companies that use the accrual method of accounting are required to record unearned revenue.
• Under the liability method, you initially enter unearned revenue in your books as a cash account debit and an unearned revenue account credit.
• Unearned revenue is not an uncommon liability; it can be seen on the balance sheet of many companies.
• Businesses that record and recognize revenue correctly avoid misstatements, SEC scrutiny, and costly tax penalties.
• This can be anything from a 30-year mortgage on an office building to the bills you need to pay in the next 30 days.

The Financial Modeling Certification

In this article, we’ll explain the key differences between unearned and deferred revenue. We’ll also explore their nuances and implications for financial reporting. 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 company receives the cash immediately, but the car hasn’t been delivered, so the payment is recorded as unearned revenue. Once the car is built and handed over, the company can recognize the $5,000 as earned revenue. On January 1st, to recognize the increase in your cash position, you debit your cash account $300 while crediting your unearned revenue account to show that you owe your client the services. In cash accounting, revenue and expenses are recognized when they are received and paid, respectively. Trying to convert unearned revenue into earned revenue too quickly, or not using a deferred revenue account at all, can be classified as aggressive accounting. If revenue gets posted to the income statement too early, it can overstate actual sales revenue.

This is why unearned revenue is recorded as an equal decrease in unearned revenue (a liability account) and increase in revenue (an asset account). The business has not yet performed the service or sent the products paid for. Unearned revenue is reported on a business’s balance sheet, an important financial statement usually generated with accounting software. If a business entered unearned revenue as an asset instead of a liability, then its total profit would be overstated in this accounting period. The accounting period were the revenue is actually earned will then be understated in terms of profit. At the end of the second quarter of 2020, Morningstar had $287 million in unearned revenue, up from $250 million from the prior-year end.

Understanding why customers leave, using data and insights, is the first step to retaining them. Keep customers using your service and head-off churn before it happens. The matching principle states that revenue for a period should match with expenses over the same period to calculate net profit. Some landlords may also offer a better rate for prepaying part or all of a lease term in advance. GoCardless helps you automate payment collection, cutting down on the amount of admin your team needs to deal with when chasing invoices. Find out how GoCardless can help you with ad hoc payments or recurring payments.

The company classifies the revenue as a short-term liability, meaning it expects the amount to be paid over one year for services to be provided over the same period. Landlords, companies that provide a subscription service, or those in the travel or hospitality industry may receive the majority of their payments for unearned revenue. Companies that use cash accounting don’t use unearned revenue or follow GAAP. Over time, the liability gradually gets converted into income (earned revenue) as the product or service gets delivered.

Unearned revenue is money received by an individual or company for a service or product that has yet to be provided or delivered. It can be thought of as a “prepayment” for goods or services that a person or company is expected to supply to the purchaser at a later date. On July 1, Magazine Inc would record $0 in revenue on the income statement, since none of the money has been earned yet. Cash on the balance sheet would increase by $60, and a liability called unearned revenue would be created for $60 to offset it. On a balance sheet, the “assets” side must always equal the “equity plus liabilities” side. Hence, you record prepaid revenue as an equal decrease in unearned revenue (liability account) and increase in revenue (asset account).

Unearned revenue is money a business receives before it delivers goods or services. In other words, it’s cash received for a promise to deliver something in the future. Usually, this unearned revenue on the balance sheet is reported under current liabilities. However, if the unearned is not expected to be realized as actual sales, then it can be reported as a long-term liability. 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. This is because the company has an obligation to provide goods or services in the future in exchange for the payment it has already received.

As the prepaid service or product is gradually delivered over time, it is recognized as revenue on the income statement. 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.