Unearned Revenue

Subscription revenue is one of the most popular streams for new companies, as it provides customers a simple way to signup and a consistent stream of cashflow over a longer period of time than a single purchase.  However, with quarterly or annual contracts, customers often pay upfront, meaning that the company has received cash before providing the service—leading to unearned revenue on the company’s books.

In these subscription-based business models, customers can either pay monthly or lock in a better deal by paying upfront for a longer period of time (be that 6 months, a year, or even longer).  When the company receives advanced payments from their customers and still owes the delivery of a product or service, the company has to account for this unearned revenue by waiting to recognize the revenue on its Income Statement. The company must classify the advance payment as deferred revenue which is a liability until earned. Read on to understand more real-world examples of unearned revenue as well as its benefits and how it should be recorded.

Understanding Unearned Revenue

Unearned revenue, or deferred revenue, is an accounting practice where upfront payments is received for products or services that have yet to be delivered. Classic examples of unearned revenue include rent payments made in advance, prepayments for newspaper subscriptions, annual licenses for the use of software, and much more.

Unearned revenue is typically considered a current liability on a business’s balance sheet because, at that point, the business is in debt to the customer (or whichever entity gave the company the case advance for their products or services). Receiving money before a service is fulfilled can be beneficial. The early receipt of cash flow can be used for any number of activities, such as paying down any outstanding interest on debt the company may have or purchasing more inventory that can help to sustain future cash flow.

Example of Unearned Revenue

A common scenario that many technology startups have is when they have a platform that is sold to the customer for a monthly fee. An example of unearned revenue in this scenario would be if a customer were to purchase a full year of access to the company’s tech stack for $1200/year. In order to get this deal, the customer is required to pay the company in full on the spot.

Once the $1200 has been received, the company enters this amount as a credit to unearned revenue. After four months, the company can recognize 33% of unearned revenue in the books, equal to $400. At this point, the company’s balance sheet would carry $800 worth of unearned revenue in the revenue of $400.

Advanced Deferred Revenue Recognition

Under the latest GAAP Revenue Recognition guidelines codified in ASC606 Revenue from Contract with Customers, Deferred Revenue analysis now requires a 5-step process that takes into account the total contract value, implied and explicit discounts or sales promotions, any variable or fixed considerations (e.g., varied price based on API calls, or fixed price no matter the usage), and cancellation rights.  Companies need to carefully review the FASB guidance to ensure their revenue recognition is properly in line with the new revenue standard. Finvisor has ASC606 experts that can ensure you are recognizing revenue accurately and in accordance with all GAAP requirements.

The Benefits of Unearned Revenue

Even though unearned revenue is considered a liability because you haven’t technically earned it until you provide the good or service, it can still benefit you. Here are a few of the most noteworthy advantages of unearned revenue:

Improved Cash Flow

When it comes to owning a successful small business, cash will always be king. Cash is what your business uses to offset its expenses and helps you out during slow seasons. By collecting these advanced payments, your business will find it easier to keep a positive cash flow and stay afloat during hard times.

Increased Working Capital

Even though unearned revenue is considered a liability because you haven’t technically earned it until you provide the good or service, it can still benefit you. Here are a few of the most noteworthy advantages of unearned revenue:

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.

Accounting for unearned revenue is a simple, two-step process: recording the initial payment, and then recording an adjusting entry when the revenue is earned. What happens if you don’t record unearned revenue properly? Improper revenue reporting may not affect very small businesses, but it can definitely affect larger businesses.

The Endless Possibilities of Unearned Revenue

Whether you’re a small, budding startup or a large, Fortune 100 conglomerate, you’re likely to come in contact with unearned revenue at some point. Having the right tools in place and people to forecast these liabilities can help you stay profitable and balance your books in a way that helps keep your cash flows in the green for the foreseeable future.

*This blog does not constitute solicitation or provision of legal advice and does not establish an attorney-client relationship. This blog should not be used as a substitute for obtaining legal advice from an attorney licensed or authorized to practice in your jurisdiction.*

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