A business owner can utilize unearned revenue for accounting purposes to accurately reflect the financial health of the business. This type of revenue, for one, provides an opportunity to help small businesses with cash flow and working capital to keep operations running and produce goods or provide services. However, understanding how unearned revenue impacts the books and customer relationships is key to making the most out of this financial component. In summary, unearned revenue is an asset that is received by the business but that has a contra liability of service to be done or goods to be delivered to have it fully earned. This work involves time and expenses that will be spent by the business. And this is a piece of information that has to be disclosed to complete the image about the financial situation at that moment in time.
Definition and Example of Unearned Revenue
A business generates unearned revenue when a customer pays for a good or service that has yet to be provided. Unearned revenue is most commonly understood as a prepayment provided by a customer or client who expects the business to deliver an item or service on time as agreed upon at the time of the purchase.
Alternate name: Unearned income, deferred revenue
In terms of accounting for unearned revenue, let’s say a contractor quotes a client $5,000 to remodel a bathroom. If the contractor received full payment for the work ahead of the job getting started, they would then record the unearned revenue as $5,000 under the credit category on the balance sheet. The contractor would also record the $5,000 in cash under the debit category.
How Unearned Revenue Works
Businesses can profit greatly from unearned revenue as customers pay in advance to receive their products or services. The cash flow received from unearned, or deferred, payments can be invested right back into the business, perhaps through purchasing more inventory or paying off debt. Positive cash flow can keep a small business’s operations thriving. However, a business owner must ensure the timely delivery of products to its consumers to keep transactions steady and drive customer retention. This is why it is crucial to recognize unearned revenue as a liability, not as revenue.
The Magazine Model
Media companies like magazine publishers often generate unearned revenue as a result of their business models. For example, the publisher needs the cash flow to produce content through its various teams, market the content compelling to reach its audience, and print and distribute issues upon publication. Each activity in a publisher’s business strategy can benefit from the resulting cash flow of unearned revenue. Consumers, meanwhile, generate deferred revenue as they pay upfront for an annual subscription to the magazine. A publishing company may offer a yearly subscription of monthly issues for $120. This means the business earns $10 per issue each month ($120 divided by 12 months). According to the generally accepted accounting principles (GAAP), the business can account for this revenue by debiting the unearned revenue account and increasing the revenue account by the same amount each month on the balance sheet.
Types of Unearned Revenue
Some examples of unearned revenue include:
Annual magazine subscriptionsPrepaid insuranceAirline ticketsAdvance rent payments or retainers
For items like these, a customer pays outright before the revenue-producing event occurs.
Criteria for Unearned Revenue
Like small businesses, larger companies can benefit from the cash flow of unearned revenue to pay for daily business operations. However, the U.S. Securities and Exchange Commission (SEC) sets additional guidelines that public companies must follow to recognize revenue as earned. The SEC marks that revenue must be realized or realizable and earned to transfer over to the income statement as revenue. The criteria to meet those qualifications include:
Having evidence of an agreement between company and customerCompletion of delivery of goods or servicesA predetermined or fixed seller’s priceCollectibility is assured
