Business is built on trust. Trust is needed because it is rare for money and goods to exchange hands simultaneously. You can often find yourself receiving money long before you provide agreed upon services or, conversely, providing services and then waiting for payment.
Usually, things work out fine. But, what are the accounting ramifications of customers paying you before you render services?
This puts you in the position of having “unearned revenue”. Unearned revenue, sometimes called deferred revenue, is when you receive payment now for services that you will provide at some point in the future.
Be careful with your unearned revenue, though, as tax authorities across the globe have specific requirements for recognizing unearned revenue, and flouting these rules is a good way to get audited.
In this article, I am going to go over the ins and outs of unearned revenue, when you should recognize revenue, and why it is a liability. Don’t worry if you don’t know much about accounting as I’ll illustrate everything with some examples.
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Sometimes you are paid for goods or services before you provide those services to your customer. That’s the essence of unearned revenue.
Earned revenue means you have provided the goods or services and therefore have met your obligations in the purchase contract. Unearned revenue is simply the opposite.
While you have the money in hand, you still need to provide the services. This requires special bookkeeping measures to make sure you don’t forget about your customer and to keep the tax authorities happy.
Let’s look at how this works under the different accounting systems.
There are two main accounting systems: cash accounting and accrual accounting.
Depending on the size of your company, its ownership profile, and any local regulatory requirements, you may need to use the accrual accounting system.
However, even smaller companies can benefit from the added rules provided in the accrual system, so you may want to voluntarily work with accrual accounting from the start.
In cash accounting, revenue and expenses are recognized when they are received and paid, respectively. That means there is no unearned revenue. Once you are paid, the revenue goes on your income statement.
In accrual accounting, things get a lot more complicated.
Revenue is recorded when it is earned and not when the cash is received. If you have earned revenue but a client has not yet paid their bill, then you report your earned revenue in the accounts receivable journal, which is an asset.
Conversely, if you have received revenue from a client but not yet earned it, then you record the unearned revenue in the deferred revenue journal, which is a liability.
To determine when you should recognize revenue, the Financial Accounting Standards Board (FASB) and International Accounting Standards Board (IASB) presented and brought into force ASC 606.
If you are unfamiliar with ASC 606, I strongly recommend you read the related article for now and take the time to go over the entire document with your accountant at some point.
ASC 606 instructs companies to recognize revenue as earned according to the following five 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.
Basically, ASC 606 stipulates that you recognize internally and for tax purposes revenue as you perform the obligations of your sales contract.
As a simple example, imagine you were contracted to paint the four walls of a building. Each wall is massive and will take a month to paint. The customer pays you $40,000 up front.
In this case, you should allot $10,000 to each of the four walls and recognize $10,000 as you finish painting each wall.
In this way, instead of recognizing all $40,000 when the cash is received (as in cash accounting) or all $40,000 when the whole job is completed (which might help your tax situation), you recognize the revenue as you reach the milestones of the contract across all four months of work.
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Yes, unearned revenue is a liability. According to the accounting reporting principles, unearned revenue must be recorded as a liability.
A liability is something that your company owes. This can be anything from a 30-year mortgage on an office building to the bills you need to pay in the next 30 days.
Now, you might be wondering: If a liability is something you owe, then how can revenue be a liability? Well, to understand this, you need to appreciate what is meant by unearned.
In this situation, unearned means you have received money from a customer, but you still owe them your services.
Until you “pay them back” in the form of the services owed, unearned revenue is listed as a liability to show that you have not yet provided the services.
Deferred revenue affects the income statement, balance sheet, and statement of cash flows differently.
Unearned revenue shows up in two places on the balance sheet.
First, since you have received cash from your clients, it appears as part of the cash and cash equivalents, which is an asset.
However, since you have not yet earned the revenue, unearned revenue is shown as a liability to indicate that you still owe the client your services.
Since most prepaid contracts are less than one year long, unearned revenue is generally a current liability.
Unearned revenue does not appear on the income statement.
However, each accounting period, you will transfer part of the unearned revenue account into the revenue account as you fulfill that part of the contract.
This recognized revenue will appear on the income statement.
The statement of cash flows shows what money is flowing into or out of the company.
Since unearned revenue is cash received, it shows as a positive number in the operating activities part of the cash flow statement. It doesn’t matter that you have not earned the revenue, only that the cash has entered your company.
Let’s look at how unearned revenue journal entries work. Consider the following three simple scenarios. For simplicity, in all scenarios, you charge a subscription fee of $25 per month for clients to use your SaaS product.
Scenario 1: On January 31st, your client pays you $25 for services rendered during the month of January.
Scenario 2: Your client fails to pay you on January 31st for the services rendered during January and instead pays you on February 28th.
Scenario 3: Your client pays you $300 on January 1st to use your service over the following year.
This is the simplest case. You receive cash at the same moment that you earn the revenue. Since they overlap perfectly, you can debit the cash journal and credit the revenue journal.
|
Journals (January 31st) |
Debit |
Credit |
|
Cash (Assets, Balance Sheet) |
$25 |
|
|
Revenue (Revenue, Income Statement) |
$25 |
In this scenario, you need to use two sets of journal entries.
On January 31st, you earn the revenue but do not receive the cash, so you credit the revenue account the same as in Scenario 1, but instead of cash you debit accounts receivable to show that you are still waiting on the cash.
Then, on February 28th, when you receive the cash, you credit accounts receivable to decrease its value while debiting the cash account to show that you have received the cash.
|
Journals (January 31st) |
Debit |
Credit |
|
Accounts Receivable (Assets, Balance Sheet) |
$25 |
|
|
Revenue (Revenue, Income Statement) |
$25 |
|
Journals (February 28th) |
Debit |
Credit |
|
Cash (Assets, Balance Sheet) |
$25 |
|
|
Accounts Receivable (Assets, Balance Sheet) |
$25 |
In this scenario, you have received cash before you have earned the associated revenue.
On January 1st, to recognize the increase in your cash position, you debit your cash account $300 while crediting your unearned revenue account to show that you owe your client the services.
Then, at the end of each month, you will reduce the unearned revenue liability by crediting it $25 while debiting the revenue account on your income statement to show that you have now earned a portion of the deferred revenue.
|
Journals (January 1st) |
Debit |
Credit |
|
Cash (Assets, Balance Sheet) |
$300 |
|
|
Unearned Revenue (Liability, Balance Sheet) |
$300 |
|
Journals (January 31st, and the end of the next 11 months too) |
Debit |
Credit |
|
Unearned Revenue (Liability, Balance Sheet) |
$25 |
|
|
Revenue (Revenue, Income Statement) |
$25 |
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