What is Unearned Revenue?
Unearned revenue is the number of advance payments which the company has received for the goods or services which are still pending for the delivery and includes transactions like Amount received for the goods delivery of which is to be made on the future date etc.
It is a category of accrual under which the company receives cash before it actually provides goods or renders services. Under this cash, the exchange happens before actual goods or service is delivered and as such no revenue is recorded by the company. The company, however, is under an obligation to provide the goods or render the service, as the case may be, on due dates for which advance payment has been received by it and as such the Unearned Revenue is a Liability till the time it doesn’t completely fulfill the same and the amount gets reduced proportionally as the service is being provided by the business. It is also known by the name of Unearned Income, Deferred Revenue, and Deferred Income as well.
The most basic example of unearned revenue is that of a magazine subscription. When we register for an annual subscription of our favorite magazine, the sales received by the company is unearned. As they deliver magazines each month, the company keep on recognizing the corresponding income in the income statement.
Unearned Revenue is a Liability on Balance Sheet
Normally, this unearned revenue on balance sheet is reported under current liabilities, however, if the unearned is not expected to be realized as actual sales then it can be reported as a long-term liability.
As an example, we note that Salesforce.com reports unearned revenue as a liability (current liabilities).
source: Salesforce SEC Filings
Revenue in Salesforce consists of billing to customers for their subscription services. Most of the subscription and support services are issued with annual terms resulting in unearned sales.
source: Salesforce SEC Filings
Unearned sales is largest in the January quarter where most of the large enterprise accounts buy their subscription services.
source: Salesforce SEC Filings
Unearned Revenue Accounting
When a company receives cash for the goods or services that it will provide in future; it leads to an increase in Cash Balance of the company, since the goods or service is to be provided in future, the Unearned Income is shown as a Liability in the Balance Sheet of the company which resulted in proportional increase on both sides of the Balance Sheet (Asset and Liabilities). Let us now look at how it accounting works.
Suppose company XYZ pays $12,000 for a maintenance and cleaning contract to company MNC for a period of 12 months. How will MNC record this unearned sales revenue on the Balance Sheet
It will look like
Now, after working for a month, MNC has earned $ 1000 i.e. it has provided its services to XYZ, thus it will accrue its earning
Hence, $ 1000 of unearned income will be recognized as service revenue. Service revenue will, in turn, affect the Profit and Loss account in the Shareholders Equity section.
It is important to understand that while analyzing a company, Unearned Sales Revenue should be taken into consideration as it is an indication of the growth visibility of the business. Higher Unearned income highlights the strong order inflow for the company and also results in good liquidity for the business as a whole. Furthermore, unearned income doesn’t result in cash outflow in future as only Unearned Sales Revenue, a liability, on the Unearned Sales Revenue Balance Sheet, is reduced as revenue is recognized on providing the goods or services proportionately.
Popular Industries where Deferred Revenue is common includes Airline Industry (tickets booked by the customer in advance), Insurance Industry (Insurance premium is always paid in advance), Legal Firms (Legal retainer paid in advance), and Publishing Firms (subscription paid in advances) such as Magazine etc. An airline Industry usually receives the advance payment of tickets booked by customers but the actual service (travel date) usually happen at a later date and such industries are required to report the same in the Financial Statements as per the methods discussed henceforth.
Two Types of Unearned Sales Revenue Reporting
#1 – Liability Method
Under this method when Deferred Revenue is received by the business, a liability account is created. The basic premise behind using the liability method for reporting unearned sales is that the amount is yet to be earned and till that time the business should report the unearned revenue as a liability. The common liability account used in the Deferred Revenue etc.
#2 – Income Method
Under this method when unearned sales is received by the business, the whole amount received is recorded under an Income account and proportionately adjusted as the goods or service is delivered by the business over the period of time as goods or service is provided.
Let’s understand the two types of unearned sales reporting through examples of Unearned Revenue Journal Entries:
ABC is in the business of publishing Business Magazine. The company receives an Annual subscription of Rs 12000 from one of its clients on 31.03.2018 for the next year. Revenue will be earned when the magazine will be delivered to the client on a monthly basis. Balance Sheet as on 31.03.2018 will show an increase in Cash Balance by the amount of Annual subscription of Rs 12000 and Unearned Income, a liability, will be created. The said liability will decrease by the proportional amount of Rs 1000 on 30.04.2018 when ABC delivers the first installment of Business Magazine to its client. Accordingly, ABC limited will deliver the remaining Business Magazine to its client month on month and the same will result in Revenue Recognition. At the end of the year on 31.03.2019, Deferred Revenue, a liability will cease to exist and all revenue will be recognized in the Income Statement of ABC Limited.
Journal Entry under Liability Method
Journal Entry under Income Method
Unearned Sales results in cash exchange before revenue recognition for the business. However, if a business does not follow the correct accrual method of recognition of Deferred Revenue it can overstate the revenue and resultant profitability without recognizing the corresponding expenses to generate such revenue. Furthermore, that will also lead to a violation of the Matching Principle of accounting for unearned income which requires that both expense and related income should be reported in the same period to which it belongs.
Unearned Revenue (Sales) Video
This has been a guide to what is unearned revenue and its definition. Here we discuss how to account for unearned revenue on the balance sheet along with examples and journal entries. You may also have a look at these related articles on Basic Accounting –