Unearned revenue or deferred revenue is a form of advance payment received by a seller against a performance promise to the buyer.
It is recorded as soon as the transaction takes place and recognized as a current liability on the balance sheet of the seller.
Unearned revenue refers to income received from a customer for products or services that are yet to be delivered.
In simple words, it is the advance payment received from a customer against a promise to deliver products or services in the future.
The term “unearned” means the revenue has been generated but the performance is due from the seller and hasn’t been delivered. Therefore, it cannot be recorded as actual revenue or income for the seller.
Since the seller receives cash or any other form of payment, the revenue generated cannot be ignored. It must be recorded in the accounts books of the seller and buyer as well.
Unearned revenue is common for sellers with services and subscription models. It comes with the added advantage of receiving cash before delivering goods or services.
Therefore, if the seller requires cash for manufacturing goods or preparing services, the cash would already be available.
The most common example of unearned revenue is from SAAS companies offering software and application subscriptions to their customers.
Customers subscribe to the services and pay in advance for monthly or yearly subscriptions. This is a classic example of unearned revenue for a seller.
Other common examples of unearned income include rental payments, prepaid insurance, prepaid services, and subscriptions.
Sellers of goods can also generate unearned revenue by offering discounts to their sellers for advance payments. Similarly, some manufacturing or delivery orders require advance payments as a confirmation of the order.
The revenue generated in advance can be useful for the cash flow requirements of the seller. However, it creates an obligation to deliver timely services or goods to the buyer.
Unearned revenue is only recorded when a seller follows accrual accounting. In cash accounting, the seller will only record an advance payment for an order rather than recording two entries in the journal.
Unearned revenue is a short-term liability for the seller as the goods or services promised against the payment received are yet to be delivered.
Since the seller is expected to receive advance payments for quick orders or subscriptions with regular service delivery, it is recorded as a current liability in the balance sheet of the seller.
Here are a few quick reasons why unearned income is a liability.
The Seller Has an Obligation
The seller has an unfulfilled promise to the buyer. An obligation exists to complete the order for goods or services promised by the seller.
Therefore, the correct accounting treatment for unearned income is to record it as a liability for the seller.
The Revenue is Uncertain
There is always an element of uncertainty with advance payments received from buyers. The seller may not be able to deliver promised services or goods within due time.
On the other hand, the buyer can also cancel the order at any time. Therefore, the seller records it as a liability on the balance sheet before confirming it as earned revenue to the income statement.
It Prevents Overvaluation
Overvaluation of income is a big concern for companies in the service industry or businesses with intangible assets.
Recording unearned income as a liability prevents the overvaluation of income for the seller. Otherwise, accounting manipulation may lead to window-dressed profits for these companies.
Compliance with GAAP Rules
Recognition of unearned revenue immediately as a liability is in compliance with the GAAP rules and accrual accounting principles.
So, recording unearned income as a liability also fulfills the legal obligation of the business.
As soon as the seller receives an advance payment, it should be recorded in the bookkeeping records as a liability.
The first journal entry to record the unearned revenue transaction by the seller can be recorded as:
The seller may provide the services or goods at once or in installments depending on the contract between both parties.
If the seller provides services/goods over several accounting periods, it can record the journal entry for each transaction as below.
So, as the seller delivers on the performance promise, the unearned revenue is converted into earned revenue.
Suppose Blue IT company is a SAAS provider and it offers many of its software products through annual/monthly subscription plans.
Let’s assume one of its customers subscribed to its digital accounting software package that costs $2,800 yearly. The subscription cost for the same software would be $250 per month.
The customer pays the full yearly amount in advance to obtain a discount of $200.
Blue IT can record the journal entry of the transaction as:
Since it is an annual subscription plan, Blue IT has two options to convert its liability into earned income.
Either, it can record a reversal entry at the end of the subscription plan as:
Or, it can recognize monthly revenue by dividing the total amount into monthly installments as:
The second journal entry is in compliance with the GAAP rules and accrual accounting principles though.
The GAAP rules state that although unearned revenue is uncertain, the seller must recognize the least-possible profit in such transactions.
It fulfills the accounting conservatism principle as guided by GAAP rules.
Accrual accounting and GAAP rules state that a business must record a revenue transaction as and when it occurs rather than when it is completed or cash is received.
Therefore, if a business records unearned revenue as a current liability in its balance sheet, it is in compliance with the GAAP rules and accrual accounting practices.
Similarly, GAAP rules prevent businesses from recognizing unearned revenue as fully recognized income. It is to prevent businesses from overvaluation of income and avoid manipulation of accounting practices to window-dress profits.
The term deferred or delayed revenue is also the same concept as unearned revenue. Both terms refer to the same concept of the future possibility of earning income for a business.
In accounting practices, both these terms are used interchangeably. Therefore, when considering unearned or deferred income, you should recognize it as a current liability.
Accrued revenue refers to the earned income for which the seller is yet to receive the payment. It means it is a confirmed revenue transaction but the buyer hasn’t made any payments.
Accrued revenue is an asset for the seller. Once the seller sends an invoice to the buyer, it records a transaction for accounts receivable under current assets.
However, it converts into cash only when the seller receives the payment.
Accrued revenue is a common form of income for most conventional businesses. Most businesses provide upfront work or goods before invoicing their clients.
For example, it is a common practice in the construction industry to receive a small proportion of the total contract in advance and then perform most of the work before the final payment is made.
Therefore, deferred revenue is a contrasting concept to unearned revenue. Deferred income is an asset while unearned income is a liability for the seller.