What Is Unearned Revenue?

Unearned revenue is revenue received from a customer before goods or services have been provided. These advance payments can improve your small business’s cash flow, since your company now has money to use to produce the requested products or perform the required services. However, in order to make the most out of this type of income, it’s important to understand how unearned revenue impacts your company’s books.

Here’s a closer look at what unearned revenue is and how to handle this type of transaction in small business accounting.

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Unearned Revenue, Defined

Simply defined, unearned revenue (also called unearned income) is a prepayment for goods and services your business yet to provide to the customer. This type of revenue provides a business with working capital it can use to fund operations and produce the promised goods or provide the promised services.

Unearned income is typically used in accrual accounting, which is an accounting method in which revenue or expenses are recorded when a transaction occurs as opposed to when payment is received or made. Unearned revenue is not a debit or credit; instead, it’s recorded as a liability (money the business owes) on the business’s balance sheet. The actual revenue is only recognized after the product or service has been delivered. At that time, an adjusting entry needs to be made.

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How Unearned Revenue Works

Businesses can benefit from unearned income because customers pay in advance to receive their products or services. This injection of cash can then be invested into the business. For example, a company might use prepayments to purchase more inventory or pay off a small business loan.

White the positive cash flow is nice, it’s important for business owners to remember that unearned income is considered a liability in small business accounting, rather than a revenue. It’s a liability because it’s essentially a debt the company owes the customer. In order to turn unearned revenue into actual revenue, the business must deliver the goods or service to the customer.

Is Unearned Revenue an Asset?

Unearned revenue is not an asset. Revenue becomes an asset once the company has earned it by delivering goods or services. Until then, the revenue is unearned, and it represents an obligation that the business has yet to fulfill.

Is Unearned Revenue a Current Liability?

Unearned revenue is an obligation that the business has yet to fulfill, which makes it a liability. The business has not yet carried out its half of the transaction (providing the merchandise or service that the customer has paid for), so it can’t recognize the payment as actual revenue.

Why Unearned Revenue Matters in Business Accounting

Properly accounting for unearned revenue ensures your business maintains financial accuracy and regulatory compliance. Understanding how unearned revenue shows up in your accounts and how it changes over time can yield insights into performance and emerging opportunities.

Impact on Financial Statements

When you read financial statements in detail, you can see where unearned revenue affects a business’s balance sheet, income statement and cash flow statement. On the balance sheet, unearned revenue increases the company’s current liabilities.

The payment for the purchase appears as operating cash flow on the cash flow statement. Once the business delivers the product or service, the money becomes earned income and is entered on the income statement.

Types of Unearned Revenue

Businesses that have unearned revenue often sell subscription-based products or other services that require advanced payments. Common types of unearned income include:

•   Service contract paid in advance

•   Legal retainer paid in advance

•   Prepaid insurance

•   Advance rent payments

•   Annual newspaper or magazine subscription

•   Annual software subscription

•   Airline tickets

Criteria of Unearned Revenue

The Securities and Exchange Commission (SEC) has established several financial reporting criteria, based on generally accepted accounting principles (GAAP), that public companies must follow in order to recognize revenue.

For unearned revenue to become earned revenue on the income statement, there must be:

•  Evidence of an agreement between the business and the customer

•  Completion of delivery of goods or services

•  A predetermined price

•  Collection probability

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Where Unearned Revenue Fits on a Balance Sheet

On a balance sheet, unearned revenue is not an asset; it’s a current liability because it is a debt until the goods or services are delivered to the customer who paid. Generally, it’s assumed that the product or service purchased will be delivered within a year, making it a current (or short-term) liability.

If, for any reason, the company is not able to deliver the goods or services, it would owe the customer the money paid, which is why it’s a debt or liability. If a business entered unearned revenue as an asset rather than a liability on the balance sheet, then its total profit would be overstated for that accounting period. In addition, the accounting period in which the revenue is actually earned will then be understated in terms of profit.

Once the product or service has been delivered, unearned revenue becomes revenue on the income statement.

Unearned Revenue Accounting

In keeping with double-entry bookkeeping, unearned revenue is always recorded in two accounts. It’s originally entered in the books as a debit to the cash account and as a credit to the unearned revenue account. The credit and debit are the same amount.

This journal entry reflects the fact that the business has an influx of cash but that cash has been earned on credit. It is a prepayment on goods to be delivered or services to be provided.

Once the business provides the goods or services, an adjusting entry is made. The unearned revenue account will be debited and the revenues account will be credited the same amount. This means that two journal entries are made for unearned revenue — one when the income is received and and one when the income is earned.

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Common Industries That Deal With Unearned Revenue

Any business may find itself with unearned income on the books, but some companies are more likely to deal with it on a regular basis. In fact, certain types of companies get most of their annual revenue from unearned income. Examples include subscription-based businesses and companies that offer prepaid service contracts.

Subscription-Based Businesses

Classic subscription businesses are very familiar; think daily newspapers, software licenses or paywalled websites. Amazon Prime and Netflix have thrived as subscription services. Customers pay a set amount at regular intervals (say, monthly) and then, for the upcoming month, have access to all benefits they’ve signed up for. As the paid-up period elapses, the unearned revenue from that month’s subscriptions is recognized as earned income.

Service Contracts and Prepaid Goods

Some businesses that rely on unearned revenue get it in the form of prepaid service contracts or retainers. Equipment maintenance contracts, legal retainers, seasonal lawn care agreements, and similar arrangements generate unearned service revenue when customers pay in advance. The customers can then claim the agreed-upon amount of goods or labor as needed. As the service or merchandise is delivered, the unearned revenue converts to earned income.

Deferred Revenue vs Unearned Revenue

Unearned revenue and deferred revenue are two different ways to describe the same thing — advance payments a company receives for products or services that are to be delivered or performed in the future. Since this revenue is a prepayment, it is not yet “earned.” It won’t be recorded as revenue on the income statement until the goods or services already paid for have been delivered to the customer. Deferred revenue is sometimes also called deferred income.

Example of Unearned Revenue

To illustrate how unearned income works in the business world, here’s an example:

Fictional company XYZ sells a movie streaming service that costs subscribers $60 up front for a full year of the service. When the customer pays $60, the owner of XYZ enters $60 as a debit to cash and $60 as a credit to unearned revenue. The full $60 would need to be recorded as unearned service revenue on the company’s balance sheet. As each month of the annual subscription goes by, the monthly portion of this total ($5) can be deducted and recorded as business revenue.

The Takeaway

Unearned revenue is money received by a company for a service or product that has yet to be provided or delivered. These advance payments are recorded on a company’s balance sheet as a liability because they represent a debt owed to the customer. Once the product or service is delivered, unearned revenue becomes earned revenue on the income statement.

Unearned revenue can benefit your small business because it boosts your company’s cash flow and gives it the cash needed to cover your operational expenses.

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FAQ

Is unearned revenue a debit or credit?

When a business receives unearned revenue, it records the amount as a credit to its unearned revenue account and a debit to its cash account.

What is an example of unearned revenue?

An example of unearned revenue is when a business sells a subscription-based product or service that requires advanced payments. When the customer prepays for the product or service, that income is considered unearned income because the goods and services have not yet been delivered.

Where does unearned revenue go on a balance sheet?

On a balance sheet, unearned revenue is a current liability.

Is unearned revenue a liability or income?

Unearned revenue is a current liability because it represents an unfulfilled obligation to deliver a product or service to a customer who has already paid.

How is unearned revenue recorded in journal entries?

Pending delivery of your business’s merchandise or service, a journal entry for unearned revenue would appear as a credit to the unearned revenue account and as a debit to the cash account. After delivery, the unearned revenue account is debited and the revenue account is credited.

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