Unearned revenue
Unearned revenue is revenue that a company has received but not yet earned. For example, a company may receive payment for a service that will not be performed until a later date. Unearned revenue is also known as deferred revenue, and is a liability for the company since it has been paid for a service that has not yet been completed.
Unearned revenue is typically recognized as a liability on a company's balance sheet, and is usually reported in the current liabilities section. This indicates that the company is obligated to provide the service or product to the customer in the future. When the company fulfills its obligation, the unearned revenue is reported as revenue on the income statement.
Unearned revenue can be further broken down into two categories:
- Prepayments: These occur when a customer makes a payment in advance for a service or product. This type of unearned revenue is typically reported on both the income statement and the balance sheet.
- Unbilled services: This type of unearned revenue occurs when a company has performed the services for a customer but has not yet invoiced them. This type of unearned revenue is only reported on the balance sheet, as it is not yet considered revenue.
Example of Unearned revenue
An example of unearned revenue is when a customer pays a company in advance for a service that will be provided in the future. For example, a customer may pay a company in advance for six months of website hosting services. In this case, the company will recognize the payment as unearned revenue on the balance sheet until the services are provided. Once the services are completed, the unearned revenue will be reported as revenue on the income statement.
Formula of Unearned revenue
Unearned Revenue = Revenue Received - Revenue Earned
The formula for unearned revenue is: Unearned Revenue = Revenue Received - Revenue Earned. This formula is used to calculate the amount of revenue a company has received, but has not yet earned. It is important to note that this formula only accounts for revenue that has been received, as revenue earned has not yet been recognized. This is why unearned revenue is reported as a liability on the balance sheet.
When to use Unearned revenue
Unearned revenue is typically used by companies that sell services or products that are delivered over a period of time. Companies can use unearned revenue to ensure they have enough funds to cover the cost of the services or products they are providing. It also serves as an indicator of future revenue, as the company will eventually recognize the revenue when the service or product is delivered. Additionally, unearned revenue can help companies manage their cash flow, as they may have a steady stream of income from unearned revenue while they are waiting to receive payments from customers.
Types of Unearned revenue
Unearned revenue can be further broken down into two categories:
- Prepayments: These occur when a customer makes a payment in advance for a service or product. This type of unearned revenue is typically reported on both the income statement and the balance sheet.
- Unbilled services: This type of unearned revenue occurs when a company has performed the services for a customer but has not yet invoiced them. This type of unearned revenue is only reported on the balance sheet, as it is not yet considered revenue.
Steps of Unearned revenue
In order to properly account for unearned revenue, companies should follow the following steps:
- Identify the source of unearned income: This can include prepayments, unbilled services, or other sources of unearned revenue.
- Record the liability: Companies should record the unearned revenue as a liability on their balance sheet. This will ensure that the company is properly accounting for any payments that have not been earned.
- Monitor the progress: Companies should monitor the progress of any services or products that have been prepaid. This will ensure that the company is aware of when the services or products have been completed and can be reported as revenue.
- Record the revenue: Once the services or products have been completed, companies should record the unearned revenue as revenue on their income statement. This will ensure that their financial statements are accurate and up-to-date.
Advantages of Unearned revenue
Unearned revenue can offer several advantages for companies, including:
- It allows companies to have more predictable cash flow: By receiving payment for services or products in advance, companies can have a better idea of their future cash flow.
- It helps to smooth out fluctuations in revenue: By recognizing some revenue in advance, companies can have more consistent revenue from month to month.
- It can help companies to plan for future growth: By having a more predictable revenue stream, companies can plan for future growth more effectively.
Limitations of Unearned revenue
Despite the importance of unearned revenue, there are some limitations associated with this concept.
- Timing: Unearned revenue can only be recognized at the time when payment is received, which may not coincide with the actual delivery of the service or product. This can lead to discrepancies between actual revenue and reported revenue.
- Revenue Recognition: As unearned revenue is recognized as a liability, it can be difficult to accurately estimate how much revenue will be realized in the future.
- Valuation: As the value of unearned revenue is based on the estimated value of future services or products, it is not always easy to determine the exact value of the unearned revenue.
Unearned revenue can also be addressed through several other approaches, such as:
- Accrual basis accounting: This approach recognizes revenue when goods are delivered or services are performed, regardless of when the payment is received. This means that unearned revenue is not reported on the balance sheet.
- Deferral and matching: This approach allows companies to defer revenue recognition until the goods are delivered or the services are performed. This approach also requires companies to match these deferred revenues with their corresponding expenses, so as to ensure that their financial statements remain accurate.
- Lease accounting: This approach is used specifically for leases. Under this approach, companies recognize revenue over the term of the lease, instead of all at once. This allows companies to avoid the recognition of unearned revenue.
| Unearned revenue — recommended articles |
| Prepaid income — Account settlement — Effective interest method — Book of original entry — Income summary — Doubtful account — Accrued income — Progress billings — Month end closing |
References
- Conrad, C. R., & DeMeritt, J. H. (2013). Constrained by the bank and the ballot: Unearned revenue, democracy, and state incentives to repress. Journal of Peace Research, 50(1), 105-119.
