Prepaid Income (known also as unearned revenue) is an accounting idea that refers to a payment that has been received, but the asset has not yet been fully delivered. In other words, prepaid income is the revenue received in advance but which is not yet earned. From the side of the company, it can be defined as the one-off payment for the asset/goods/ service that will be delivered in the future or over time (funds received from a customer prior to the provision of goods or services).
Prepaid Income is found on the Balance Sheet of a company. It has to be considered as a liability (as it is something which is owed since the seller has not delivered them yet), either with its own section or under Other Current Liabilities. As soon as the goods or services has been provided, the liability is cancelled and the funds are recorded as a revenue instead. In most of the cases, the prepaid income concept is seen in businesses that require prepayment for the manufacture of custom goods. It is not accurate in other industries, such as retailing, where payment is always made at the time of sale or later.
What is important, income must be recorded in the accounting period in which it is earned. As a consequence, prepaid income must not be shown as income in the accounting period in which it is received but instead it must be presented as such in the subsequent accounting periods in which the services or obligations in respect of the prepaid income have been proceeded.
Prepaid Income Tax Explanation
In accounting, Prepaid Income Tax is recognized as an asset listed on the balance sheet that constitutes taxes that have been already paid despite not yet having been incurred. It is also called a deferred income tax asset. Prepaid income are generally taxable under the federal income tax law.
Prepaid income tax is recognized as a form of prepaid expense. The most usual situation when prepayment on income taxes occurs is because of the over-estimation of tax deposits. In such a case, taxes are estimated from the financial records of the previous year. After the estimation, taxes are paid. Then, when the year-end taxes are found to be less than the taxes paid earlier, prepayment on income taxes has occurred. This prepayment can create one of two results. Either it results in a tax refund or the credit written off towards the tax liability of the next period.
There is one great difference between prepaid income tax and a deferred tax asset.
- Prepaid income tax within one year
- Deferred income tax asset can occur for a period of longer than one year.
Often, prepaid income taxes are the result of poor assumptions. Generally, company controllers prefers to overestimate the needed tax deposits.
Examples of Prepaid income
- Rent payments: Rent payments are a common example of prepaid income. These payments are received before the tenant is able to occupy the property. The landlord is then able to recognize income from the rent payments, but the tenant does not receive any goods or services until the tenancy begins.
- Insurance premiums: Insurance premiums are another example of prepaid income. When a policyholder pays for a policy, the insurer receives payment for a service that has not yet been provided. In this case, the income is recognized when the premium is received, even though the service may not be provided until much later.
- Prepaid Credit Cards: Prepaid credit cards are a popular form of prepaid income. In this case, a customer will purchase a card and load it with a certain amount of money. The customer then has the ability to use the card like a regular credit card, but the card issuer does not have to provide any goods or services until the customer actually uses the card.
- Subscriptions: Subscriptions are a type of prepaid income that is becoming increasingly popular. These payments are usually made in advance of the customer receiving any goods or services. For example, a customer may pay for a year-long subscription to a streaming service, but the service will not be accessed until the customer actually uses the subscription.
- Tuition: Tuition payments are another example of prepaid income. In this case, a student will pay for tuition for a course or program in advance, but the student does not receive any of the services associated with the course until the course begins.
- Advance Payment: Advance payments are a form of prepaid income that is commonly used when a customer places an order for a product or service. In this case, the customer pays for the goods or services before they are provided, and the seller recognizes the income when the payment is received.
Advantages of Prepaid income
The main advantages of prepaid income are:
- Increased cash flow: Prepaid income helps businesses to maintain a steady cash flow. This can be beneficial in times of financial difficulty and can help to cover overhead costs or finance investments.
- Improved budgeting: Prepaid income can be used to plan and budget for any future expenses, allowing businesses to better anticipate and prepare for upcoming costs.
- Reduced risk of bad debt: By receiving payments before the goods or services have been delivered, businesses can be assured of payment and reduce their risk of bad debt.
- Improved customer relationships: By providing customers with the option of prepaying for goods or services, businesses can build trust and loyalty, resulting in improved customer relationships.
Limitations of Prepaid income
- One of the major limitations of prepaid income is that it can be difficult to track and manage. This is because the asset or service that is being paid for has not yet been delivered, meaning that there may be discrepancies in the accounts. Additionally, prepaid income can be difficult to forecast, as it is not certain when the asset or service will be provided.
- Another limitation of prepaid income is that it can be difficult to determine the amount of the payment that should be recorded as prepaid income and what should be recorded as expenses or costs. This is because the amount of the prepaid income may not be known until the delivery of the asset or service.
- The third limitation of prepaid income is that it can be difficult to monitor the performance of the asset or service that is being paid for. This is because the performance of the asset or service may not be known until it is delivered and the customer has had the opportunity to use it.
- Finally, prepaid income can be difficult to manage cash flow. This is because the money may not be received until after the asset or service is delivered, meaning that there is a risk of a cash flow imbalance.
In addition to one-off payments, there are other approaches related to prepaid income that can be used to manage the accounting for revenue received before the delivery of goods or services. The approaches related to prepaid income include:
- Deferred revenue: Deferred revenue is when advance payment is received from customers for goods or services to be delivered in the future. This type of revenue is recorded as a liability on the balance sheet until the goods or services are delivered.
- Accrual-basis accounting: This method is used when the revenue is earned but not yet received. The revenue is recognized on the income statement when the goods or services are delivered, and the amount is recorded as a receivable on the balance sheet.
- Revenue recognition principle: This principle states that revenue should be recognized when the goods or services have been delivered, and the amount of revenue can be reliably measured.
In summary, prepaid income is a payment received in advance for goods or services to be delivered in the future. Other approaches related to prepaid income include deferred revenue, accrual-basis accounting, and the revenue recognition principle.
- Newton G, Liquerman R (2012)
- Thakkar V (2014)
- Dodge M, Fleming C (2012)
- Matheny E (2018)
- Murphy K, Higgins M (2009)
|Prepaid income — recommended articles|
|Trade receivables — Deferred expense — Accrued income — Accounts uncollectible — Doubtful account — Revenue expenditure — Nominal account — Purchase returns and allowances — Bills Payable|
- Dodge J, Fleming C (2012).Federal Income Tax: Doctrine, Structure, and Policy: Text, Cases, Problems, LexisNexis, Baton Rouge
- Matheny E (2018).Taxation of Public Utilities, LexisNexis, Baton Rouge
- Murphy K, Higgins M (2009). Concepts in Federal Taxation 2010, Cengage Learning, Boston
- Newton G, Liquerman R (2012).Bankruptcy and Insolvency Taxation, John Wiley&Sons, New Jersey
- Thakkar V (2014).Balance Sheet: The Tale of Asset & Liability, Network18, Noida
Author: Weronika Włodarska