Unearned revenue is the revenue a business has received for a product or service that the business has yet to provide to the customer. Any business that takes upfront or prepayments before delivering products and services to customers has unearned revenue, which is often also called deferred revenue.
Because the business has been paid but no product or service has been rendered, unearned revenue is considered a liability. The liability converts to an asset over time as the business delivers the product or service.
There are a number of industries where unearned revenue commonly occurs: subscription-based software, prepaid insurance, retainer agreements, and airline tickets.
Who Should Care About Unearned Revenue—And Why?
Any business that accrues unearned revenue should record it accordingly. First, it’s important to have resources planned for the future for product and service delivery. Without them, a business may be selling something they can’t support or deliver.
Also, the United States Securities and Exchange Commission (SEC) has reporting requirements for businesses that are specific to revenue recognition. Revenue recognition is a generally accepted accounting principle (GAAP) that dictates how revenue is accounted for. According to GAAP, unearned revenue is recognized over time as the product or service is delivered, based on certain critical events.
The SEC has set criteria for how revenue is recognized. Thanks to the recent adoption of Accounting Standards ASC 606, revenue recognition rules are now more uniform (where they used to be industry-specific).
Want to learn more basic accounting terms? We’ve compiled a list of terms we think business owners should know.
Where Is Unearned Revenue Recorded?
Unearned revenue is recorded on a company’s balance sheet under short-term liabilities, unless the products and services will be delivered a year or more after the prepayment date. If that’s the case, unearned revenue is listed with long-term liabilities.
Because there is a possibility that the services may not be performed (whether because a customer backs out or a business is unable to perform them) they present a risk to the company. While it’s assumed that money will one day be recognized, it can’t be guaranteed until the work is performed. Therefore, it belongs as a liability until the risk of repayment is gone.
When Is Unearned Revenue Recognized?
According to ASC 606, businesses must recognize revenue when they have delivered products or services that are equal to the amount in exchange for those same products and services. This process includes the following 5 steps:
- Find and review the contract with the customer.
- Identify what the business obligation is in the contract.
- Determine the appropriate amount for the transaction.
- Allocate that amount towards the contracted obligation.
- Recognize the revenue when the business satisfies the obligation.
Let’s say a bakeshop pays up front for custom web development to build out the shopping cart on their website. The web development firm receives a $10,000 payment upfront.
For each accounting period, the web development firm will look at what they are contractually obligated to do for the bakeshop, what they actually did during that period, and then determine how much of the total of $10,000 it represents. Let’s say they were obligated to and performed three-quarters of the total contract in a 90-day accounting period. The web development firm would then recognize $7,500 in revenue for that period.
At that point, the unearned revenue amount of current liabilities would drop by $7,500, and the cash could then be listed as a current asset instead using an adjusting journal entry.
Ready to take control of your business’ finances? Chat with a ScaleFactor expert today and see the software in action.
Your ultimate guide to SMB accounting
Let’s get those books in order.