Do you collect deposits from customers or bill them before delivering your product or service? If so, you have unearned revenue.
Unearned revenue isn't discussed as much as other financial concepts, such as cash flow or accounts receivable, but it can play an important role in your business finances.
This article explains what unearned revenue is for small business owners. We’ll also go into how to account for it so you can make the most informed decisions when managing your business's finances.
What Is Unearned Revenue?
Unearned revenue is any money you've collected from clients in advance of providing goods or services. It’s also known as deferred revenue, prepaid revenue, or unearned income. In essence, it is income that you've received but not yet earned.
In financial accounting, unearned revenue is a liability on your balance sheet—not an asset. While you might deposit the money into your bank account, the revenue isn’t really yours until you deliver the product or service, so it shouldn’t show up on your income statement.
Is It a Short-Term or Long-Term Liability?
In many cases, any unearned revenue on your books will be a short-term liability (also known as a current liability) because you expect to earn the revenue within the current accounting period—usually within the next 12 months.
However, in some cases, your deferred revenue might be a long-term liability. This is the case if you don't expect to either earn the revenue or return the deposit to your customer within the next year.
For example, let’s say you collect a security deposit from a tenant on a three-year lease. Because you don’t expect to convert it to revenue within the next 12 months, that deposit would be a long-term liability account.
When Is Unearned Revenue Used?
Unearned revenue is mainly used in accrual accounting, which recognizes revenue as soon as its earned.
Meanwhile, companies that keep their books on a cash accounting basis don't have an unearned revenue account. They simply recognize revenue when cash comes in and recognize expenses when cash goes out.
Examples of Unearned Revenue
Examples of unearned revenue include:
- Tickets for travel, sports, entertainment, or any other event planned in the future
- Landscaping, cleaning, or maintenance fees charged in advance
- Legal fees
- Rent or lease payments
- Insurance premiums
- Magazine or newspaper subscriptions
- Software
Let’s look at one of these in depth:
Say you own a lawn maintenance company. At the beginning of the year, you present your clients with an alternative payment option: If they pay in advance for a year of your services, you'll give them a 10% discount. So instead of paying $200 per month, they'll pay $2,160 annually, which works out to $180 per month.
Customer A takes you up on your offer and sends you an advance payment of $2,160 in January. Recording the entire $2,160 as revenue in January wouldn’t be right because the prepayment covers 12 months of lawn maintenance services. If you don't provide the agreed-upon services, you'll be obligated to refund Customer A's money.
Instead, you would record the $2,160 as unearned revenue. Then, at the end of each month, you can recognize revenue for that month with a journal entry.
Now, let's cover what those journal entries look like.
How to Record Unearned Revenue Journal Entries
In double-entry bookkeeping, journal entries contain two components: a debit and a credit.
So returning to the example above, when you received payment for future services from Customer A at the beginning of the year, your entry to record it in your books needs a debit and a credit. Your initial entry would be:
By the end of January, you've performed that month's lawn maintenance services, so you want to move the monthly portion of the customer's deposit to your income account. Your adjusting journal entry would be:
At the end of each month, you make this same journal entry until you’ve recognized all of Customer A's revenue in your books.
However, say after six months, Customer A decides they no longer need your service. Assuming you don't have a clause in your contract stating that all payments are non-refundable, you would refund half of their annual subscription fee. Your entry would be as follows:
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